This article is the third installment in a three-part series focused on important valuation and dilution considerations during fundraising. Also see part-one: Avoiding Startup Valuation Traps: 409A vs. Fundraising, and part-two: The Role of Convertible Debt and SAFEs in Fundraising.
Equity dilution occurs when a company issues new shares, reducing existing shareholders’ ownership percentage. While dilution is a common fundraising effect, founders must manage it carefully to maintain control and value.
Some Key Considerations:
- Cap Table Management: Regularly review the cap table to understand dilution effects across funding rounds.
- Pro-Rata Rights: A provision that gives investors the ability to maintain their proportional ownership by purchasing additional shares in future rounds.
- Anti-Dilution Provisions: These protect investors from excessive ownership dilution in down rounds by adjusting the conversion price of their preferred stock; there are two common types: Weighted-average and full ratchet.
- Option Pools: Employee stock option pools increase dilution; plan these strategically.
Important Definitions: Pre-Money vs. Post-Money Valuation
Understanding the difference between pre-money and post-money valuation is crucial for fundraising strategy.
- Pre-Money Valuation: Company’s value before new investment.
- Post-Money Valuation: Value after adding the new investment.
- Formula: Post-Money Valuation = Pre-Money Valuation + New Investment
Example Dilution Scenario:
- Shares Outstanding: 10 million (50-50 split between two founders)
- Outstanding SAFEs: $1M with post-money cap of $8M
- Priced Round: Investment: $5M at $15M pre-money valuation
- Post-Money Valuation: $20M
- Option Pool: For simplicity, let’s assume no option pool.
When there is a priced round, the first step is to convert the SAFEs. Because the priced-round valuation exceeds the cap, the SAFEs’ % equity stake—before factoring in the dilutive effect of the priced round—is their investment of $1M divided by the cap of $8M, so 12.5%. If there were 10M shares outstanding before SAFE conversion, the share count after SAFE conversion will increase to 10M/(1-12.5%) = 11.429M shares. At this point the founders’ stake is down to 87.5%.
In the second step, we incorporate the investors in the priced round.
- How much of the company are they entitled to (again overlooking option pools)? $5M/$20M or 25%, which is their investment divided by the post-money valuation.
- What price per share will the new investors pay for their stock? The pre-money valuation, divided by fully diluted shares (including SAFE conversion but excluding priced-round shares). So $15M/11.429M or $1.31/share, which buys the new investors 3.810M shares ($5M/$1.31). The total amount of shares will be 11.429M shares / (1-25%) = 15.238M shares. This equals 11.429M (shares after SAFE conversion) + 3.810M (priced-round shares). (Please disregard rounding on share count.)
After all that, the founders initial 100% stake has been diluted down to 65.625%. Bear in mind that an option pool would cause further dilution to the founders and the SAFE investors. It’s not uncommon for the priced round investors to call for the option pool to be increased to 10-15% in preparation for the hiring of new employees. In this example, the creation of a 10% option pool would dilute the founders down to 56.875%.
Step 1: SAFE Conversion
- SAFE % = $1M / $8M = 12.5%
- Total Shares = 10M / (1 – 12.5%) = 11.429M
Step 2: Priced Round Conversion
- Investor % = $5M / $20M = 25%
- Price/Share = $15M / 11.43M = $1.31
- New Shares = $5M / $1.31 = 3.810M
- Total Shares = 15.238M
- Founders’ Ownership = 10M/15.238M = 65.625%
Conclusion
By understanding valuation and dilution, founders are on their way to optimizing their fundraising efforts and ensuring long-term success. Remember, valuation is an important reflection of your company’s potential and a key determinant of its future. Ultimately, building a successful startup is a marathon, not a sprint, and strategic valuation decisions are essential mile markers on that journey.
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