How to manage equity dilution as an early-stage startup

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When you’re fundraising, it can be easy to get swept up in the moment—you’re excited about money coming in, and you don’t immediately have to give up anything concrete in return. But your fundraising decisions come with long-term implications that are critical to think through.

One of the most important things to consider when fundraising is the impact of dilution. In this guide, instead of teaching you how to calculate dilution (we have a free calculator that’ll do all the math for you), we’ll show you how to plan for dilution—we’ll walk you through a high-level overview, which elements you can control, and when you can control them.

What is equity dilution?

Dilution is the decrease in equity ownership by existing shareholders that happens each time you issue new shares, like during a fundraising or when you create an option pool.

For example, let’s say you’re the sole owner of your company and you own 10,000 shares. Your company is doing well, so you decide to create an option pool of 1,000 shares for future employees. You also give an investor 2,000 shares in return for some much-needed capital. In total, there are now 13,000 shares of company stock—and just like that, you now own only 77% of your company (10,000/13,000) instead of 100%.

Dilution can change both your financial stake in the company and how much control you have, so it’s important to understand how raising money can impact your ownership, especially early on. Below, we’ll cover two common methods of early-stage fundraising: SAFEs and priced rounds.

SAFEs and equity dilution

A SAFE (Simple Agreement for Future Equity) can be a convenient way to raise money when your company is young. However, SAFEs can be extremely dilutive. Here’s what you need to know:

What is a SAFE?

A SAFE is a type of convertible instrument that allows you to quickly raise money from an investor now in exchange for future shares of stock in your company. This allows you to postpone big decisions, like how much your company is worth, until later.

In exchange for their investment, your SAFE holder gets shares when you do your next round of “qualified financing” in the future, often at a discount and/or with favorable terms. These favorable terms help attract investors and account for the added risk they take by investing in your company at such an early stage.

How does equity dilution work when raising a SAFE?

SAFEs essentially allow you to postpone dilution until your next qualified financing (usually your Series A). This can make it tempting to accept the terms of a SAFE without thinking about the future ramifications. However, it’s essential to understand the dilutive power of SAFEs because the decisions you make when raising convertible instruments could have a major impact on your ownership in the future.

While many things can influence how dilutive SAFEs will eventually be, there are three main details you should understand and watch out for.

Pre-money vs. post-money SAFEs

 

The type of SAFE you raise can impact your eventual dilution.

  • With pre-money SAFEs, each investor’s ownership percentage is up in the air until you raise your next round, at which point the math plays out and everyone learns how much they own. This type of SAFE may be less dilutive for you, the founder, since everyone’s ownership gets diluted at the same time.
  • With post-money SAFEs, investors lock in the percentage of the company they’ll own before the new Series A (or other qualified financing round) investors get mixed in. Many investors and founders prefer this type because it gives everyone a better idea of where they’ll land in terms of ownership, making it easier to plan for the future. However, post-money SAFEs are generally less founder-friendly because none of the other SAFEs dilute each others’ ownership percentage—they just dilute yours.

It may be helpful to figure out which type of SAFE you want to raise before deciding the next element: the valuation cap.

Valuation caps

Many SAFEs come with a valuation cap to protect the investor. A valuation cap is the maximum valuation—for purposes of determining the share price—at which your investor’s money converts into equity.

This means if your company valuation at Series A is higher than your SAFE valuation cap in the seed round, your SAFE investors will receive a lower price-per-share than the Series A investors do, giving your SAFE investors more shares for their investment.

As you can imagine, if your priced round company valuation ends up being way larger than the valuation cap, you may end up issuing a lot of shares to that SAFE holder, which can significantly dilute your ownership.

Conversion discounts

A conversion discount gives your investor a discount on the price per share when their SAFE turns into equity. For example, if your Series A investors are paying $1 per share, your SAFE holder may only have to pay 80 cents per share, giving them more bang for their buck.

Conversion discounts usually range between 15% and 20%, which isn’t usually worth arguing too much about. In most cases, a valuation cap will likely be more dilutive than a conversion discount. 

If a SAFE comes with both a valuation cap and conversion discount, the investor usually gets whichever 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 usually longer and more complicated than raising a SAFE, but there’s less guessing involved when it comes to dilution. Here’s what you need to know.

What is a priced round?

In a priced round, investors give you a certain amount of money for a certain number of shares based on the company valuation you agree upon with your investors.

How does equity dilution work when raising a priced round?

In addition to the dilution that happens when you issue your new investors their shares, early priced rounds, like a Series A, are also when your past decisions (e.g. SAFEs) usually come into play.

While many factors can influence dilution during priced rounds, there are three main details you should understand and watch out for:

Pre-money vs. post-money valuation

Whenever you raise money in a priced round, be sure to understand whether the valuation you and your investor agree upon is your pre-money or post-money valuation. Why? Because it’ll impact how much the new investment dilutes your ownership.

Say your investor gives you $1 million for a valuation of $4 million. If that $4 million is your pre-money valuation, that means you own 80% of the company after the investment. However, if that $4 million is your post-money valuation, you only own 75% of the company after the investment.

Pre-money valuation Post-money valuation
Pre-money valuation: $4 million

+

Investment: $1 million

=

Post-money valuation: $5 million

Pre-money valuation: $3 million

+

Investment: $ 1 million

=

Post-money valuation: $4 million

You own: 80% of the company ($4M/$5M) You own: 75% of company ($3M/$4M)

5% may not sound like a big difference, but when companies are worth millions or even billions of dollars, every percent matters, so you really want to preserve as much of your ownership as possible.

Any convertible instruments, such as SAFEs, you issued before your round

If you raised money via SAFEs or other types of convertible instruments, your Series A is usually when all these convert into equity.

When you raise an early priced round, it’s easy to just focus on the piece of your company you’re selling to your new investors and forget about the other investors you promised shares to. As you figure out how much money you want to raise and how much of your company you can afford to give away, just keep in mind this round will likely be way more dilutive than you’d expect once you factor in the shares you owe to all your SAFE holders.

Your option pool

Another way you could accidentally take on too much dilution in a priced round: forming a bigger option pool than you need. An option pool is a chunk of shares you create and set aside for future employees. The key detail to note is that you’re creating and adding new shares, not pulling them from your existing set of shares, so option pools end up diluting your ownership.

Here’s the thing: investors often ask you to create an option pool before you issue their shares so only previous shareholders are diluted, not them. (And if you’re the only shareholder thus far, this means only your ownership gets diluted.) Additionally, they may push you to create a bigger option pool than you need so you don’t have to add more options and dilute their ownership sooner than they expected.

Before creating an option pool, do your best to figure out your hiring plan for the next one or two years and how many shares you think you’ll want to award those employees. That way, if investors pressure you, you can always point to the numbers.

How to minimize equity dilution

The bottom line is when you’re fundraising, it’s important to keep in mind that you’re not playing with Monopoly money. Every decision you make can have a real impact on how much you own and eventually walk away with when you sell your company.

While many of the things we talked about above are unavoidable, there are some strategies you can take to minimize dilution:

    • Don’t raise more than you truly need to get to the next stage of your business. The money you borrow early on in your company is the most dilutive. Since early investors get equity when your company is worth less, each dollar they invest buys a proportionally larger stake of your company. Of course, this doesn’t mean you should underestimate how much you need—raising additional seed capital isn’t easy, so be sure to forecast and aim for an amount that’ll help you meet the operating plan you presented to your original investors and get you to the next stage of your business.
    • Don’t create a bigger option pool than you need. Investors may ask you to allocate more than you need, but if you create a hiring plan, you can always show how you came up with your ideal pool size, which may help with negotiations.
    • Try not to rush your decision. Before signing a term sheet or SAFE, take the time to understand the terms and conditions. The decisions you make now will have long-term ramifications.
    • Model your future dilution. By the time you realize the impact of dilution, it’s usually too late to do anything about it. So whenever you’re thinking of fundraising, no matter the method, model the impact of dilution first.

Carta’s SAFE and convertible note calculator

In the past, models took hours to build, and you often had to be proficient in Excel or cough up a ton of money to pay a lawyer to build one for you. Now there’s no excuse—we’ve built a SAFE and convertible note calculator that can help you model the potential dilution no matter the type (e.g. pre-money SAFEs or post-money SAFEs) and number of convertible instruments you’re thinking of raising. With our free calculator, you can view your pre and post-money dilution before and after a future priced round and visualize your ownership at multiple future valuations.

Want to read more? Learn how to model a round or check out some tips and tricks for using the calculator. And if you’re interested in creating and issuing SAFEs, we can help you with that, too.

At Carta, we help startups with fundraising, compensation, valuations, equity management and much more. Talk to us to find out how we can help you grow.

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta Inc. (“Carta”).  This communication is for informational purposes only, and contains general information only.  Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services.  This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests.  Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor.  This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein. ©2021 eShares Inc., d/b/a Carta Inc. (“Carta”). All rights reserved. Reproduction prohibited.

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