The issue of dilution is central in most entrepreneurs thinking. Founders start their businesses owning 100% and every time they raise additional capital that number gets chipped away. It goes without saying that the intention behind raising capital is that you increase the size of the pie – ‘80% of something is better than 100% of nothing’ etc.
The actual implications of dilution are often not thought through quantitatively though.
We’ve cribbed some data from a Shareworks report1 that analyses valuation and equity raise data for 10,000 US-based start-ups to illustrate some often-overlooked points.
First up, we answer the common question around how much founders give up at each round. The data suggests that founder dilution per round peaks at Series A/B before declining in later rounds.
Applied cumulatively over multiple rounds, the second chart shows founders usually retain majority ownership of their business until the Series B stage. In practice, the arrival of institutional capital in a Series A round usually signals the end of founder control of the company. It’s also important to call out that ‘employee ownership’ includes any employee stock option plans to incentivise new hires, so founder ownership is lower across the board.
The flipside of dilution is of course the value that is hopefully generated by the additional capital raised. Mean pre-money valuations by stage indicate something close to an exponential increase in value over time as a start-up raises successive rounds of capital (shown in orange).
So far so good for the Silicon Valley gospel.
These numbers are skewed by the outliers though – the 0.14% of start-ups destined to become a unicorn (see the post When is venture capital the best choice?). Median valuations give a much better approximation for the uplift experienced by most start-ups. Looking at these numbers, there is an almost perfect linear growth rate from one round to the next (shown in grey).
So, what does that mean for Founder returns?
Well the averages look great – up and to the right. But again, these figures are skewed by the Ubers, the Facebooks and the Stripe’s of the world. The median values tell a different story. The median founder at Series A holds ~$5M in equity value. By Series D this has increased to just $7M, and has actually declined from Series B. A huge amount of hard work, sacrifice and personal risk exists between a company at Series A stage, and one at Series D. Based on median values, start-ups that reach Series D will be worth 6x their Series A value. The data suggests that founders are not reaping the rewards of that graft – so who does?
You guessed it, it’s the investors. Average investor value mirrors that of founder value, but for median value it is significantly steeper than its founder equivalent.
Why? Well most people think of dilution as the % of equity you give up to raise new money. But that’s really the narrowest conception of the term. When VCs invest, they demand investor protections like liquidation preferences, participation rights, anti-dilution protection and sometimes other level-ups like cumulative dividends. These terms tilt the scales and de-risk the investors return at the expense of the founders.
If you’ve managed to create the next Instagram, chances are you’re swamped with funding offers and can dictate your own terms. Most companies need to hustle and pitch for funding though and the leverage usually sits with the investor. Subsequent investors will at a minimum seek to match any terms from a prior round. Agree to a 2x liquidation preference? Chances are your investors in the next round will want the same.
What should founders do to manage this? Well first off remember that you control the bank account. Investors can push you to spend more, bringing your next funding raise into view faster – but its you that has the ultimate say. When thinking about a round, focus on what you need to reach your next milestone and only raise more than that if its offered on terms that work for you. Read the small print, model out the downside scenarios of those investor protections and consider the implications for any subsequent raises.
Finally, remember that dilution can be managed by securing better terms and raising capital sensibly, but it can be solved by building a business that can sustain itself and scale with its own profits.
At Double Down we back founders looking to solve for profitability, who want to control their own destiny and measure their success based on the revenue they earn not the funding they raise. Join us, and double down on what you do best.
(This article is builds on the concepts set out by Bryce Roberts in his post ‘Meaningful Exits for Founders’)