In the startup environment, founders walk a tightrope between raising capital and protecting their equity. Picture this: you devote everything to growing a business and with every funding round you participate in, you see your ownership equity slowly disappear. Founder equity dilution is a hidden threat that can pull the rug out from under your entrepreneurial aspirations; that being said, if you understand the landscape and develop the necessary skills, you can mitigate equity dilution just as you seek to grow your startup.
Founder Equity Dilution
Dilution can take on many forms, and each form has its unique set of problems. New investors come with new cash but they also dilute the ownership percentage of existing shareholders. That in turn can lead to losing control of the direction of your company due to being outnumbered by new shareholders. In addition, the economics of ownership diminish. A founder’s share of the overall profits will shrink over time. There’s also an important psychological toll. Founders can feel betrayed or disillusioned when they see their equity reduced.
A Deeper Analysis of the Risks
At its core, in order to fully grasp the potential negative impact of dilution, it is essential to consider all forms of dilution. Primary dilution occurs when new shares are issued to new investors, or existing shareholders, which increases the total number of outstanding shares. Secondary dilution occurs when founders buy back shares from existing investors, shrinking the ownership percentage of each existing investor. Internal dilution occurs when the founders issue new shares to themselves, reducing the size of their ownership stake. Each of these forms of dilution individually comes with their own implications, but the real issue is the compounded impact of all types of dilution on the founder’s ownership control and share of the spoils.
Founder Equity Preservation Tactics
1. Preemptive Rights
One of the best ways to alleviate dilution is to obtain preemptive rights. This provides the founders the opportunity to buy more shares in proportion to their existing holdings prior to any new investors coming in. If this is accomplished, the founder retains the ownership percentage and the ability to control the company’s future.
2. Valuation Growth
A higher valuation in funding rounds means fewer shares need to be issued to raise the same amount of total capital. Founders also should be prioritizing demonstrating superior growth potential and negotiating the best valuation possible to limit any dilution. Not only is equity preserved, but it gives investors confidence in the company’s future.
3. Alternative Financing
Debt financing is another tool to minimize dilution. Although debt financing comes with its own risks (e.g., higher liability), it allows founders to raise money without giving up ownership. Finding the right mix of debt and equity can be a great way to achieve growth with less ownership loss.
4. Anti-Dilution Clauses
Anti-dilution clauses can protect founders from ‘down rounds’, which are rounds where the company sells at a lower valuation than previous rounds. Anti-dilution clauses establish a measure of protection to avoid founder dilu-tion when external conditions fall (i.e. poor performance). The weighted average method is best practice for founders, because it adjusts the conversion price, it is based on the weighted average of both existing prices and newly introduced shares, thus leading to less dilution than full ratchet.
5. Strategic Use of Convertible Notes
Convertible notes with a valuation cap or discount to the next financing round, acts as an anti-dilution mechanism. These instruments convert to equity at a later time, often at a discount to the next financing round’s valuation, thus limiting the impact of dilution on note holders.
How Evolve Venture Capital Can Help
At Evolve Venture Capital, we recognize the ambivalence between securing funding and maintaining founder equity. We have walked down this road with many founders who are grappled with this tension, and our experienced team will offer its counsel and prudence as you navigate the vagaries of equity dilution. We provide researchers with insights into negotiating valuation. We provide direction on how to structure funding rounds with the goal of limiting dilution. We share insights regarding anti-dilution clauses as well as other funding alternatives that may apply in your situation. You can rely on Evolve Venture Capital to provide guidance on the nuances of protecting your equity, so you can continue to build your vision and take the necessary steps to manage dilution.
In conclusion, we recognize that dilution of founder equity is an unavoidable part of the startup saga, but it does not have to be the end of your business ambitions. If you apply some smart tactics and leverage the expertise of partners like Evolve Venture Capital, you will lessen the fallout of dilution and be able to keep most of the equity that you have sacrificed to build your startup. The idea is not to completely avoid dilution; but rather to preserve where possible to stay aligned with the vision of your business past, present and future.
