How to Manage Dilution on Early Stage Startups

As per statistics by commerce and Industry Minister Piyush Goyal, there were 726 early-stage startups in 2017 and 65,861 in 2021.

The market is highly competitive for startups in early stage. The founders of startups in early age are highly focused on growth in a short time. The founders rarely understand that startup funds and management equity are precious weapons. A plan should be carefully laid, mentioning the use of money and its purpose. 

Hence, when an early-stage startup firm receives equity, it must use it optimistically and wisely. 

For many founders, there is a celebration when they raise capital in the early stages. The fundraising process so drives them that they often don’t understand the long-term repercussions of their decision of startup dilution and end up regretting the Startup dilution in the long run. Let us quickly understand what startup equity dilution is.

Startup Dilution:

Assume that it’s your birthday and you’re on an island enjoying yourself with your partner. You get a cake, and both of you decide to enjoy the same on the beach. Coincidentally, one of your college friends is on the same beach. You guys meet, and he joins in with his wife and kid. In such a situation, the cake would be cut into five pieces.   

The above example is the perfect explanation of equity dilution. You and your partner are the company’s founders, while the cake is the equity. Initially, you and your partner had a 50% stake in the cake that has now been reduced to a mere share of 20% each (assuming that the cake was divided in 5 equal pieces). Your friend and his family now own a part of the equity. 

Equity dilution happens when the ownership of the existing shareholders reduces, and a part of the equity goes to the investors. An equity dilution can reduce the founder’s financial stake and ownership in the company. This happens when the founders decide to dilute their equity in lieu of the investments they seek for their startup. 

The valuation of a company goes up when the investments flow in. This tempts a lot of early-stage startups to raise funds at levels of pre-money and post-money valuations. But it is essential to understand that fundraising has several long-term implications. One such implication is equity dilution. In this blog, we will understand how equity dilution works in the pre-money and post-money SAFEs and the steps a founder can take to minimize equity dilution. 

Understanding How Dilution Commonly Happens in an Early-Stage Startup:

SAFEs Agreement

A Safe(Simple agreement for future equity) is a kind of agreement between the investor and the early-stage startup that allows the company to raise funds in exchange for the company’s future stock without deciding the price per share at the time of initial investment. If you are an early startup, then SAFE can be a convenient way to raise funds. 

Now the question arises: 

Should early-stage startups prefer pre-money or post-money SAFE options? 

Pre-Money SAFE: When the founder of a company goes for a pre-money option, the investor’s percentage of ownership is not determined until the next priced round. Generally, founders choose the pre-money option because that is significantly less dilutive. 

Post-Money SAFE: The founders and Investors fix the latter’s percentage of ownership before the next financing round. It is a better option to go for the investors as the percentage of ownership is certain. It makes it easier for the founders to plan for the future. 

It is essential for the founders to carefully understand the nitty gritty of the SAFE agreements so that they can manage equity dilution in a better manner.    

How to Manage Dilution of an Early-Stage Startup

When raising money through SAFEs or any other convertible instrument, the founders often focus on finding ways to raise money. However, it is important to consider how much ownership you are willing to dilute and the number of shares you can afford to give away to SAFE holders. This will give you a more holistic view of the dilution process. 

Let us now understand how the founders of early-stage startups can minimize their equity dilution:

1. Raise money only when you need it – 

Instead of chasing the funding rounds, determine the amount of money you would require on different heads. The money you raise in the earliest stage of your startup is the most expensive as your company’s worth is not determined or is much less. In the initial phase of your startup, try to raise less capital against equity. 

2. Make an option pool early on: 

An option pool is a chunk of shares that the companies generally keep aside for their future employees. Before creating an option pool, a company must lay down its hiring plan for the next few years and anticipate how many shares they are willing to share with its management and employees as management equity. Whenever a company adds new shares or pulls out an option pool from the existing startup equity, it results in startup equity dilution. 

When raising funds through any source, calculate an ideal pool size. Remember that the bigger the option pool, the more the early stage dilution. Investors prefer a bigger pool size because it implies that it will last longer. They would also want to create an option pool before you issue their shares so that their stake in the company is not diluted further. An ideal pool will help you make better negotiations.

3. The Caps will guide you on how much to raise: 

A valuation cap is a company’s valuation at which the investor’s money is converted into shares. If the company’s valuation at the time of seed fundraising is higher than that at the time of SAFE, the SAFE investors will receive a lower price per share when compared to seed investors. Every company must formulate its valuation cap at a startup stage. The caps guide the founders and protect the investors on how much dilution would happen during the SEED round. 

Companies at the startup stage are often in a rush to add more funds to grow at a fast pace. The golden tip is that one must not rush into the fundraising process and consider the long-term ramifications of fundraising as it would significantly impact the company’s future and startup equity. Founders must understand the terms and conditions of fundraising before signing the term sheet.