Start-up Dilution (1)
MARCH 6TH, 2017
I was recently approached by a friend who is thinking of taking venture capital money for his start-up, but is concerned (rightfully) about dilution of his equity stake. As of right now, he owns approximately 81% of the company, with the remaining 19% belonging to a group of angel investors (mostly friends and family) and a small stock-option pool.
We decided to model out his specific dilution path, factoring in the imminent Series-A round from the VC, a follow on convertible note ‘bridge’ round of $2 million, and a final $5 million Series B ‘growth capital’ raise. The dilution results are typical of what most entrepreneurs face when raising capital in today’s environment, thus I thought I would share them here.
Lets start by looking at the Series A round. The VC in this scenario has issued a term sheet stipulating 20% ownership of the company. They also require an employee stock option pool to be implemented (in this case, 8% of outstanding shares).
There are actually two dilutive events here. The first is the option pool, which is typically established prior to the VC investment. This way the VC is not diluted by the creation of the pool. In other words, a 10% pre-money option pool will be established prior to the investment, with the knowledge that it will be diluted to the desired 8% pool size after the Series-A investment is finalized (10% x (100% - 20%) = 8%).
Thus, all existing shareholders are diluted firstly by the creation of the option pool, and secondly by taking in the VC investment. In our example, the founder will own approx 58% upon completion of the Series-A round, a 23% decrease in ownership stake over his original ownership.
We then assumed a ‘bridge’ round of approx $2 million would be needed. This would be satisfied using convertible debt, or debt that automatically converts to equity upon a qualified financing event (hypothetically, upon an investment of $3 million or more). The debt converts at exactly the same valuation as the Series-B capital, which makes for a straightforward calculation. It is not unusual to see convertible debt convert at a discount to the qualified financing- a mechanism that provides incentive to invest in the convertible debt round, and not simply wait for the qualified financing.
The Series-B round math works in exactly the same way as the Series-A round. In this case, we assumed the VC will require approximately 20% of the company for their $5 million investment- a $25m post-money valuation. Also, they will require a replenished option pool; in this example, we assumed the option pool will be replenished to 15% of outstanding shares. Again, the pool would be established prior to the Series-B investment, so existing shareholders will be diluted by a total of 18.75% (18.75% x (100% - 20%) = 15%) first, then by an additional 20% upon the Series B investment.
As mentioned above, there is actually a third layer of dilution associated with the Series B raise. The Convertible Note ‘bridge’ round will convert at the same valuation as the Series-B capital.
I will follow on with a GoogleDocs dilution calculator that will allow you to see the dilution progression by round, and play with the variables (valuation, raise amount, bridge round discount, stock option pool replenish %, etc.).
Every situation is different, but it’s valuable to know how this works in general terms, and that all start-ups are likely to face dilution of varying degrees.
