Dilution in Future Funding Rounds

A subject that early-stage investors care deeply about is future dilution: how much of a particular company will they own if/when they can exit an investment? The question is an important one because unlike more traditional investments such as stocks or real estate, startups generally receive multiple rounds of outside investment. Each investment round results in additional dilution as the ownership pie is cut into more pieces.

As with much in the world of startup investing, the answer to the question of how much an early-stage investor will own is: “it depends and varies dramatically from one startup to another.” To the extent that there is a “typical” path for a successful startup, it could look something like the following.  Note, of course, that most startups fail after the seed round.

Early-Stage Round 1

Acme Inc. raises $500k using convertible notes with a 20% discount, $4 million note cap and conversion into preferred stock. Jill, an early-stage investor, invests $50k.  Jill’s ownership is uncertain because we don’t yet have a valuation for the company, but the note cap ensures that the early-stage investors in this round collectively will own at least $500k/$4 million, or 12.5%.  Jill has 1/10th of that, or 1.25%.

Early-Stage Round 2

A year goes by and Acme Inc. needs another seed round to hit additional milestones before raising a Series A and issues another $500k in convertible notes. The terms are the same except the note cap is raised to $8 million to account for an increase in the company’s value. Jill invests $25k this round. Again, the company still does not have a value so Jill’s ownership stake is uncertain. However, we know it will be at least 1.25% (round 1) + 1/20th of $500k/$8 million (round 2), or 1.25% + .3125% = 1.56%.

Series A

18 months after Early-Stage Round 2 Acme Inc. proves product-market fit and raises $5 million on a $10 million pre-money valuation.  Jill does not participate in this round.

Early-Stage Round 1 will convert into preferred stock at the $4 million note cap, not the $10m Series A valuation, and Jill will receive 1.25% ownership from her initial investment.

Early-Stage Round 2 also will convert at the note cap value (or discount, the methods provide the same result in this example) and Jill will receive an additional .3125% for a total of 1.56%.

The Series A investors will own ⅓ of the company.

Series B

Two years later Acme Inc. makes progress but decides to raise a Series B to help with international expansion. The company raises $10 million on a $30 million pre-money valuation.  Assuming that the preferred stock that Jill owns does not have any anti-dilution protection, her stake will be reduced in proportion to the equity acquired by the Series B investors – ¼.  She will therefore own .75 * 1.56% = 1.17% of the company.

Series C

Another 18-months go by and Acme raises $50 million on a $200 million valuation. As with the Series B, assume that Jill does not have anti-dilution protection. Her stake will be reduced by ⅕, to .94%.

Acquisition

Acme Inc. continues to perform well and, seven years after raising Early-Stage Round 1, is acquired for $500 million in cash. Jill receives a payout of .94% * $500 million, or $4.7 million.

The Funding Simulator is a useful tool to determine ownership percentages and payouts under multiple financing scenarios.

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