September 29, 2020

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by: Jonathan Hung

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Tags: startup founder

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Categories: Startup Funding

Equity Dilution for Founders- How to Keep from Getting Fully Diluted.

Equity dilution doesn’t have to be a scary term, but you should understand it when you’re a founder.  Being a startup founder comes with a ton of responsibilities and pressures. Aside from wanting their company to be successful and hoping they make enough cash to cut themselves a reasonable salary after the first year or so, founders must also try to avoid becoming fully diluted – in other words, they want to prevent themselves from losing control of their company.

But this is easier said than done, especially since equity dilution is one of the cornerstone strategies for acquiring investment cash and drawing in new blood to a company as it grows. Although equity dilution isn’t truly avoidable for most entrepreneurs, there are ways a startup founder can keep themselves from getting fully diluted. Let’s break those down in this guide.

A Short Review – What Is Equity Dilution, and Is It a Bad Thing?

Equity dilution is a term that describes progressively lower ownership in a company or venture. This sounds bad on its face, but it’s actually a necessary part of the business for the vast majority of entrepreneurs.

In a real business environment, most entrepreneurs have a great idea and begin a company with only a small seed or nest egg. Once that company’s basic service or product has been proven, they can start attracting and acquiring investment cash to grow their operations and, in turn, boost the overall company’s equity or value.

However, many investors, knowing that a new startup company can’t afford to pay them back directly for investment capital, will instead trade investment funds for equity or shares in that company. In this way, investors own a part of a company and become committed to that company doing well over the long-term.

For a founder, this is both good and bad. It’s good because they get the capital they need to grow their business to the next stage. But it’s also bad because it means they have to give up some of the ownership of their company, and some of the future value they believe the company will hold.

This being said, equity dilution is largely harmless in practical terms, and if it’s handled correctly. An entrepreneur with a startup worth $10 million after the first year can use equity dilution to acquire investment cash, then grow that company to be worth $200 million two years later. Even if the founder’s equity in the company went from 100% to 40%, they’d still have grown their personal equity’s value to $80 million, for comparison.

In summary: equity dilution is an important part of early business investment and is something that many businesses continue to practice as they grow larger and require more cash to evolve. This often takes the form of offering equity or shares to employees, making an initial public offering or IPO, and attracting other investors with traditional shares of the proverbial company pie.

Ways to Avoid Becoming Fully Diluted

While equity dilution is far from something to be avoided (at least, if you’re a startup founder that doesn’t have infinite cash for his or her enterprises), you don’t want to become fully diluted. In such a case, your ownership of the company would be either gone or essentially nil. This is bad both for future control of the company and for your own investment return – after all, you invested months and possibly years of your life into this venture, and you want to be rewarded as your startup takes off.

To avoid full equity dilution, a startup founder needs to employ several preventative strategies as they intelligently dilute said equity. In other words, there are right ways and wrong ways in which you can dilute your equity in your company. Let’s examine some of the former.

Don’t Be Greedy… At Least At First

Some successful entrepreneurs will tell you that the initial money you earn is the most “expensive” of your company’s history. What they mean is that it’ll cost you more, in terms of both time and effort, and in terms of equity or shares, to get the initial investment you need to get your startup off the ground compared to any other, later rounds of investment.

Put another way, it’ll cost much more equity to get $10 million in investment at the beginning of your startup’s success than it would to get another $10 million in investment once your company is sitting at total equity of $200 million and is one of the most successful in its industry or niche.

This means, accordingly, that you shouldn’t be greedy when doling out equity or shares to potential investors and employees. You should also be quite careful about collecting as much investment cash as you can.

There’s a school of thought in the entrepreneurial sphere that you should always try to acquire as much investment money as possible, regardless of the consequences. But this is shortsighted and can accidentally result in your equity becoming fully diluted and you losing control of your company, plus missing out on the great rewards later down the road.

For startup founders, here’s what you should take home:

  • Don’t pursue more investment cash than you need
  • Figure out a single number, as accurately as you can, for the amount of money you need to reach the next step for your business’s evolution. Then go after it
  • If an investor offers more cash for more of a stake in your company, don’t necessarily agree. Review your findings from earlier and decide yes or no based on that information

It can be tempting to take the entire money pot offered by an enthusiastic investor who wants 51% of your company. But if you don’t need all the money they offer, don’t take it. If your company is really worthwhile, you’ll make all that cash and then some and still have some equity left behind to enjoy the spoils.

Don’t Forget Your Cap Table!

A capitalization table is a type of table that describes the percentage of ownership (i.e. the number of shares) that all the shareholders of a business have. Your cap table is something you should review regularly, both in the initial stages of your business and as equity dilution becomes a more regular part of your business operations.

You should use your cap table to project the effects of different funding options. For instance, you can examine how a new round of investment would dilute the stakes of any existing shareholders, including yourself, and the potential impacts on profits that may result in down the road.

Find Investors Who Share Your Business Goals… and Who You Trust

This is a bit of a no-brainer, but it’s especially important to prevent yourself from becoming fully diluted. You should always prioritize investors that share in your business’s goals and who you can personally trust. This is true for general investment – you don’t want to be taken advantage of by an investing shark, of course – but it’s also important so that your equity is never threatened or diluted more than you want it to be.

This is easier said and done for many startup founders, especially those that may not have the cash or connections to be choosy about where their investment funding comes from.

But it’s almost always worthwhile to hold off on investments that seem like poor choices, or money that comes from investors that clearly see your enterprise as a momentary cash cow they can milk to destruction before making a hasty exit.

In this aspect of business, as with all others, try to trust those with whom you do business and those who share in the ownership of your company.

Don’t Rely on Investing Notes for Too Long

Many startup founders will draw in an initial round of investments using investment vehicles, such as convertible notes or SAFEs (which stands for “simple agreement for future equity”). Basically, these investment notes defer the decision about how much equity and investor will receive to a later date.

However, many SAFE and other convertible notes include discounts or other terms that offer the initial investors for your company special bonuses. This makes sense and really is fair when you consider that they are taking a bigger risk than even the first “real” round of investors.

But this does mean that, if you rely on these convertible notes or SAFEs for too long, you could accidentally end up diluting too much of your equity as your company’s value raises with success. Furthermore, you’ll get more pressure to raise a price round of investment with high valuation as the amount you raise through the notes grows. In this way, you can almost become a victim of your own success.

You don’t want to accidentally give away a majority of your company just from the earliest round of investment. Take care when using SAFEs and other notes, and combine this idea the advice above to make sure you use them correctly and wisely.

Avoid Giving Employees Equity After You’re in the Clear

Many startups rely on hard-core employees who are willing to bleed for the company in question. This dedication is matched by a willingness to take, and sometimes even a demand for, shares or equity in a company instead of a particularly high salary.

Indeed, many startup employees want to believe that they are working for the next Google, so they’ll be content with a piece of the equity pie, dreaming of fortunes they’ll earn as soon as the company really takes off.

As a founder of a startup, this is great news for you and your company. You need that kind of dedication, and you need skilled employees that don’t demand high salaries when cash is absolutely essential, and every penny counts. This being said, handing out shares and diluting your equity to your employee base is only a wise move to a point.

Indeed, as your company succeeds and you bring on a bigger workforce to handle more customer requests, more business, and other development of challenges, you should seriously reevaluate your policy of paying your employees through shares and equity.

It’s all too easy to accidentally hire a ton of employees, keeping the same equity dilution language in the hiring contract, then discover that you simply hired too many people who contractually have a stake in your company such that you’re now totally diluted and don’t have the share you thought you did.

Granted, you should already be reviewing employee contracts as you grow and build your company from the ground up. But many startup founders forget this point since they’re used to equity being a deal sweetener (and may even have experience with sharing equity in companies themselves).

Above All, Keep a Clear Head and Review Your Figures Frequently

There’s a running theme in all of this advice – most fully diluted founders are those who don’t pay attention or who lose track of all the moving pieces of their new business. You can’t really fault them for this, as making a startup and sending it soaring to success is one of the hardest things you can do in life.

However, it’s also true that avoiding full equity dilution is pretty simple when you break things down and keep a clear head. Always review your cap sheets. Review your employee contracts. Make sure that you make smart investments. All this advice is both general and versatile, and it applies as much to equity dilution avoidance as it does to any other aspect of the entrepreneurial sphere.

Bottom line: make decisions clearly and carefully and don’t run headlong into any contracts or agreements without looking at all the effects down the road.

Conclusion

Ultimately, a startup founder would be wise to keep themselves from getting fully diluted, both initially and as their company grows and becomes more successful. But it’s a fine line to walk between avoiding full dilution and diluting enough such that one’s company has the fuel and cash it needs to survive and thrive in today’s competitive business market.

When in doubt, contact experienced entrepreneurs or investment angels like Jonathan Hung for advice, answers, and further guidance as you grow your startup.

 

Jonathan hung, Angel InvestorAbout the Author

Jonathan Hung is one of the most active angel investors in Southern California, his mission is to drive value creation within each portfolio company. In support of this mission, he serves as Co-Managing Partner at – Unicorn Venture Partners.

Jonathan and his team target investments in US companies that have global market potential with a focus on long-term growth expansion to East Asian markets.

Jonathan developed his investing prowess as a Managing Member for his family office fund, J Heart Ventures, which made investments in start-up companies such as Gyft, ChowNow, Miso Robotics, Clover Health, Bitmain, to name a few startups he funded.

Jonathan has various degrees from the University of Southern California, London School of Economics, Massachusetts Institute of Technology, and The Wharton School at the University of Pennsylvania.