Once you start fundraising for the company, it is easy to get carried away—of course, you are excited about money being added, and you won’t have an immediate need to provide anything solid in return. However, your fundraising decisions have long-term implications which are essential to think thoroughly.
One of the most significant aspects you need to factor in while fundraising is the influence of dilution. This guide will provide you an overview of how to plan for dilution—offering a general explanation of equity sharing, which components you can control, and when you can manage them.
Equity Dilution
Dilution is described as the decrease in equity ownership by current shareholders which occurs whenever you issue new shares, such as during fundraising or when you build an option pool.
For instance, suppose you are the sole owner of your company and you have 10,000 shares. The company is doing better, so you plan to build an option pool of 1,000 shares for prospective employees. You also provide an investor with the 2,000 shares in exchange for some well-deserved capital. Therefore, altogether there are 13,000 shares of company stocks now—and now you only own 77% of your company i.e., 10,000/13,000 rather than 100% of the shares.
Dilution can change both, your financial stakes in the company and the extent of control you have over your company. Therefore, it is essential to understand how financing your money can impact the ownership, particularly early on. In the following, the two most-used methods of early-stage fundraising are discussed: SAFEs and priced rounds.
SAFE and Equity Dilution
A Simple Agreement for Future Equity (SAFE) can be a convenient method to raise funds when the company is young. Nonetheless, SAFEs can be extremely dilutive.
A SAFE is a kind of convertible tool allowing you to rapidly raise money from an investor now in exchange for future stock shares in your company. It allows you to delay the big decisions, like the worth of your company, until later.
In exchange, your SAFE holder gets shares when you do your next stage of ‘qualified financing’ in the future, sometimes at a discount and with favorable conditions. The favorable terms and conditions help attract investors and account for the added risk they take by investing in the company at an early stage.
Role of Equity Dilution When Raising a SAFE
SAFE essentially allows you to postpone dilution until the next qualified financing (typically the Series A). It can make it tempting to accept the terms of a SAFE without considering the future implications. Nonetheless, it is important to understand the dilutive power of SAFEs as the decisions you make when increasing convertible tools could have a great impact on your own in the future.
While various things can impact the dilutive SAFE will eventually be, there are three major details you should understand and look for.
Pre Money vs. Post-Money SAFEs
The kind of SAFE you increase can have an effect on the eventual dilution.
- With pre-money SAFEs, every investor’s ownership percentage is greater unless you raise the next stage, where calculations about shares come into play and everyone understands their share of ownership. It can be less dilutive for the founder, as everyone’s ownership gets diluted simultaneously.
- With the post-money SAFEs, investors lock in the percentage of the company shares they own before the new Series A (or other qualified financing rounds) investors get mixed in. Several investors and founders prefer the post-money SAFE as it gives them the liberty of understanding the status of their ownership, making it easier to plan for the future. Nonetheless, post-money SAFEs are typically less founder-friendly as no other SAFEs dilute each other’s ownership percentage—they are only diluting yours.
It can be helpful to figure out the types of SAFE you want to raise before deciding the next component i.e., the valuation cap.
Valuation Caps
Many SAFEs come with a valuation cap to protect the investor. A valuation cap is a maximum valuation—for reasons of determining the share price—at which your investor’s money converts into equity.
This implies that if your company valuation at Series A is greater than your SAFE valuation cap in the seed stage, your SAFE investors will get a lesser price-per-share than the Series A investors do, allowing your SAFE investors more shares for the investment.
As it can be imagined, if the prices round company valuation are greater than the valuation cap, you are expected to have trouble in the form of giving many shares to the specific SAFE holder, resulting in significantly diluting your ownership.
Conversion Discounts
A conversion discount allows your investor a discount on the price per share when their SAFE converts into equity. For instance, if your Series A investors are paying USD1 per share, your SAFE holder may just have to pay 80 cents per share, giving them more liberty for their money.
Conversion discounts typically vary between 15 to 20%, which is not much debatable. In the majority of the cases, a valuation cap will be expected to be more dilutive than a conversion discount.
If a SAFE comes with a valuation cap and conversion discount, the investor typically gets whatever option gives them the lower price per share (i.e., more shares for their money).
Priced Rounds and Equity Dilution
The process of raising a priced round is typically longer and more complicated than increasing a SAFE, but there is less guessing involved in the dilution.
In a priced round, investors provide a specific amount of money for a certain number of shares depending on the company valuation you agree upon with the investors.
Role of Equity Dilution When Raising a Priced Round
In addition to the dilution when you issue the new investors their shares, early priced rounds like a Series A, are also when your past decisions like SAFES usually come into play.
Although there are several factors influencing dilution during the priced stages, but the following three details must be sought after and understood thoroughly:
Pre-money vs. Post-Money Valuation
Whenever you raise money in a priced round, be certain to understand the valuation you and your investor agree on is your pre-money or post-money valuation. This is because it will impact how much the new investment dilutes the ownership.
- Suppose your investor gives one million for a valuation of four million. If the USD four million is the pre-money valuation, this suggests you own 80% of the company after the investment.
- Nonetheless, if the four million comes in the post-money valuation, you just own 75% of the company after the investment. 5% may not look like a huge difference, but when companies are worth millions of dollars, each percent matters, hence, you would want to preserve as much of the ownership as possible.
Any convertible tools, like SAFEs, you issued before your round. If you raised funds through SAFs or other kinds of convertible tools, Series A is generally when all these convert into equity.
When you raise an early-priced round, it is convenient to focus on the piece of your company you are giving to your new investors and ignore other investors you committed your shares with. As you realize the amount of money you are required to increase and the share of the company you are willing to give up, you must realize this phase will be more dilutive than you would usually expect when you include your owed shares to all the SAFE holders.
Option Pools
One other option that takes much dilution in a priced stage, building a greater option pool than that’s required. An option pool is a piece of shares you build and set aside for future workers. The major detail to ponder is that you are building and adding new shares, not pulling them from the current shares, hence, option pools end up diluting the ownership.
Investors usually create an option pool before they assign the shares therefore old shareholders are diluted. Moreover, they may compel you to build a greater option pool than you require so you won’t need to include more options and dilute the ownership earlier than they expected.
Prior to building an option pool, it is best to consider a hiring strategy for the coming years and the number of shares you would want to award the employees.
Parting Remarks
In a nutshell, while you are fundraising, it is essential to understand you are not playing monopoly. All your decisions will have a real influence on how much you own and withhold when you sell the company.
The following strategies can be employed to minimize dilution. Do not raise more than you truly need to get to the next phase of your business. Do not create a greater option pool than you require. Keep a level-headed approach when deciding the equity shares, don’t rush your decision. Lastly, you can model the impact of your future dilution.