Impact Of Equity Dilution On Early-stage Startup

Aakriti

4th Nov'22
Impact Of Equity Dilution On Early-stage Startup | OpenGrowth

What happens if you pour water into a glass that is half full of orange juice? 

There are a few things,

Filling the glass with more liquid reduces the juice's flavor and power. 

Share dilution functions similarly, despite the fact that it may seem strange to start a conversation about equity with an analogy. A firm dilutes its shares when it issues additional stock shares, thereby increasing its outstanding shares. However, the current shares' representation of the company's ownership decreases, and each of those shares see a slight decline in value. The potency of existing shares is diluted when new shares are issued, just like how orange juice's effectiveness is diluted when water is added.

Share dilution, sometimes referred to as stock dilution or equity dilution, maybe a challenging subject for businesses and shareholders to negotiate, and juice metaphors can only take us so far. In this blog, we'll go over the fundamentals of share dilution and observe how the dilution of shares works in a startup. It's crucial to highlight up front that while share dilution doesn't always hurt existing shareholders, it can have negative consequences if it's done without a sound plan for using the extra shares to raise the company's value.

Fundraising is thrilling because it shows that investors have enough faith in your concepts and product roadmap to give you money to expand. But before taking any new cash, fundraising decisions have important long-term consequences that must be carefully considered, such as share dilution.

What is share dilution?

computer and mobile phone

Share dilution is the process of decreasing a company's equity stake by issuing more shares that will be put up for sale. When a company's percentage of equity held by existing shareholders is decreased, dilution takes place, allowing the freed-up shares to be used for capital raising.

The initial ownership of firm stock is distributed among investors, with the remaining shares set aside for public trading. They are referred to as public floats.

The number of split shares of a corporation rises when listed company equities are made available on secondary offerings. The money made is frequently utilized to finance the company's expansion or pay off debt.

How Much To Dilute?

There is no right response to this query. It is arbitrary and, among many other things, is based on the stage of your business. Naturally, you can negotiate better if your business is doing well. When deciding how much dilution to choose, the following considerations must be made:

  • Future investors may become concerned if there is excessive dilution.

  • However, investors may be turned off if the founders' shareholding is overly restricted since they want to be involved in the business.

However, your startup's main objective is to expand. Therefore, it is crucial that you maintain the business's expansion in mind even if the dilution statistics differ from the dilution numbers you anticipated. You can achieve this aim more quickly with investments.

First off, it's critical to comprehend that equity dilution can be beneficial and detrimental to a corporation. Startups can raise money through equity financing to support growth even if they might not be able to immediately repay investors. Businesses also don't have to worry about repaying their investors, and occasionally it even enables them to obtain more information and resources (if they raise capital through sources such as venture capitalists and angel investors). However, it is also detrimental because it results in control loss and lost potential earnings.

Example

computer screen on a table.

For instance, if the company is currently valued at $15 million and you own 70% of it, you would have $10.5 million in your pocket. You made the decision to grow your business, giving venture investors 40% of your shares in return for $8 million. This enables you to gather the resources you need to develop your business to a $30 million valuation. Your equity, however, is now worth $9 million. Your business has expanded, but your funds have not.

Although there isn't a perfect amount of equity you should give up, you should aim to give up 10% to 20% of your company's equity at the seed stage rounds. In funding series A, companies can anticipate losing 15% to 25% of their investment. You should anticipate giving up 20% to 40% of your company by the time Series C or D fundings are complete.

So what steps should you take? Start by doing some accurate forecasting, and a decent lot of math, and seek assistance in understanding the legalese. How do you ensure you're on the correct route, though, given that it could be challenging to keep track of your equity dilution? How does the dilution of shares work in startup?

Here is some guidance from successful startup founders and advisors:

Take only what you need

Before approaching investors, be sure you know exactly how much money you need. Especially while it could be alluring, try to avoid it unless you actually need the money, even if investors request more shares in exchange for bigger investments. This will not only assist you in maintaining control over your startup but also help you avoid over-scaling it. If you have too much financing available, your customers may have higher expectations of your company, which, if you are unable to meet them, could damage your brand's reputation. It may also limit the amount of money that may be put back into the company for expansion. In other words, your demise may result from your greed for funding.

Start with debt financing rather than equity financing

Startups that attempt to get money from venture capitalists or angel investors frequently fail to accomplish so or end up losing too much equity in the process. Investors would probably want a bigger equity stake in exchange for the same investment if the startup is still in the ideation stage as opposed to if the company is currently operating. Bootstrapping, which is a method of raising finance from personal funds, friends, and family, is what you should do in the beginning. As an alternative, consider using debt to finance your business. This will enable you to keep the funding you require while minimizing the dilution of your share.

Gradually give up equity stakes

work table with files and hands.

Giving up tiny stock holdings throughout each round of investment, as opposed to substantial equity stakes all at once, might aid businesses. Instead of giving up 10% to 15% in round A if you are raising money through a venture capitalist, try giving up between 2% and 6%. This will enable you to raise all the money you require over the coming months and years, expand your firm, and increase the price per share in subsequent rounds. You might eventually grow to the point where you don't need equity funding and you haven't even diluted your equity as much as you would have if you gave in to the 20% stake.

Plan your ESOPs pool to avoid unnecessary dilution

If you're an early-stage business, offering equity shares to your employees is a terrific approach to get people enthused about your firm and lower employee turnover. Plan your ESOPs pool to avoid needless dilution. You might want to go above and beyond for your employees, but it's recommended to stick to offering your initial staff 0.1% to 0.3% stakes in order to prevent needless dilution.

Engage investors who are focused on your business objectives

The most crucial factor is to make sure you have faith in your investors. Working with shark investors or not knowing your investor's objectives could result in you being taken advantage of and having to forfeit your stake. Working with investors who don't comprehend your aims can cause your organization to go in the incorrect direction because they also acquire ownership of it with each stock stake.

In conclusion

It's critical to monitor the equity dilution of your startup and make sure you retain primary control of your company if you want to assure the success of your venture.

OpenGrowth provides experts on-demand ready to navigate you through the unique challenges you may encounter on your entrepreneurial journey. Explore our diverse roster of experts today and empower your startup to reach its full potential.

A student in more ways than one. Trying to feed her curiosity with news, philosophy, and social commentary. 

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