Early-stage investors are often diluted by future funding rounds before they are able to exit an investment. The extent of the dilution depends and varies dramatically from one startup to the next.
Pre-money refers to the valuation of a start-up before the new round of money is raised. Post-money refers to the valuation after the raise. Thus, if you hear someone say that a company raised “$5 million at $10 millon pre,” you know that the pre-money value of the company was $10 million, and the post-money value is now $15 million.
Dilution refers to the percentage of ownership dropping after each round, as new investors join. Founders start out owning 100% of their company, but they give up a percentage of ownership during each round of funding, diluting their percentage. The same holds true for investors.
Suppose the pre-money value is indeed $10 million, and the founders own 70% of the company and the first round investors own 30%. $5 million of new money comes in, post-money value is $15 million. The new investors own 33% of the company. The founders now own just 70% of the remaining two-thirds — or 46%. Their ownership percentage has been diluted from 70% to 46% with the new investors coming in. The first round investors have also been diluted from a 30% to 21% ownership stake.
The hope, of course, is that the company will continue to grow in value, and that the new ownership stakes, although smaller in portion, will end up more valuable.
The Convertible Note Simulator is a helpful tool to understand dilution under various funding scenarios.