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Is your skin actually in the game? Here's how startup founders avoid excessive equity dilutionIs your skin actually in the game? Here's how startup founders avoid excessive equity dilutionIs your skin actually in the game? Here's how startup founders avoid excessive equity dilution

Is your skin actually in the game? Here's how startup founders avoid excessive equity dilution

Raising pre-seed or seed funding? Set the right terms from the start and follow these steps to prevent excessive founder equity dilution down the line.

TL;DR: while founder equity dilution is inevitable in the fundraising game, you should also protect your participation in your own startup. To avoid excessive founder equity dilution, remember to:

  1. Set clear and favorable terms from the start;
  2. Limit excess funding with post-money SAFEs;
  3. Be wary of pro-rata rights;
  4. Base your ESOP pool on data;
  5. Limit the amount of stock dilution via accelerators and advisors. 

Imagine starting a widely successful startup and selling it for millions, maybe billions of dollars. The only catch? You're making almost nothing from the sale yourself.

Sounds unlikely? Unfortunately, it happens all too often to founders who don’t plan around equity dilution, get unfavorable terms while fundraising, and end up closing unreasonable deals–so unreasonable that they make you wonder if the founders still have skin in the game. And other investors might think that as well, dooming your future rounds.

Want to avoid falling into pitfalls like that? Follow the steps below to run away from excessive equity dilution in your startup.

Latitud is uniting the best entrepreneurs, investors, and builders of Latin America's startup ecosystem in Vamos Latam Summit. Learn more about the event and get your tickets!

First, how does equity dilution even work?

When you founded your startup, you and your co-founders likely received 100% of your company's shares. With each round of funding, new shares are created for investors. 

How many they get depends on how much investors think your startup is worth and the amount investors decide to invest.

Besides valuation and round size, you should also know the difference between pre-money and post-money valuations to check your equity dilution. Let's see what happens in both cases.

Founder equity dilution with a pre-money valuation

Imagine your company has 10 million shares, a US$1,000,000 pre-money valuation, and an angel investment of US$250,000. The angels will get 2.5 million new shares at US$0.10 per share. You’ll now have a total of 12.5 million shares, of which you’ll still own 10 million, or 80%, and the angels will own 2.5 million, or 20%. In the end, you saw a 20% dilution.

Founder equity dilution with a post-money valuation

Imagine your company has 10,000,000 shares, a US$1,000,000 post-money valuation, and an angel investment of US$250,000. In this case, the pre-money valuation was US$750,000, which means the price per share is just US$0.075. If your angels invested US$250,000, that gives them 3,333,333 new shares. Now, your company has a total of 13,333,333 shares. You'll be left with 75% of the shares (10,000,000) while your inventors will own 25% (3,333,333). In the end, you’ve suffered a 25% dilution.

How much equity dilution should you aim for per round?

Founders of startups are used to losing the majority of their company’s ownership by the time they raise Series B funding. But sometimes this happens even earlier—and that's a problem. The best practice is for founders to have 50% to 60% of the companies by the time they finish a Series A. Not achieving this means that a founder might be excessively diluted.

Founders end up with unreasonable equity dilution because:

  1. Ownership was excessively diluted during previous funding rounds;
  2. Startups participate in multiple accelerator programs;
  3. It tends to take longer to achieve profitability.

Aim for a dilution of between 15% and 20% per round. That's advice from Dan Green, partner at the global law firm specializing in tech Gunderson Dettmer. 

If you’re going way beyond that or doing a lot of rounds, you can get way too diluted and kill your startup's financing prospects. 

"No matter how promising or amazing the company and the founders are, VCs will move on from a cap table that's out of line with their expectations for the most part. They have other opportunities that involve less friction in terms of investing."

But you also can't have terms that are too aggressive on the other side of the spectrum. "You can have such founder-friendly terms that they become off-market. Investors might think that's a weird signal that the founder is so control-oriented and focused on their business that they aren't willing to share any dilution."

Remember: fundraising is a long-term game in which you must balance your interests with those of your investors. And dilution is a huge part of it.

5 steps to avoid even further founder equity dilution

1. Plan for later rounds

The name of the game in early-stage financing is planning. With every round of funding, you’re setting precedents for further rounds. You need to be careful from the start in your equity dilution, because future investors will want similar terms as past investors.

"You have to play the chess game and think a couple of steps ahead", says Dan.

Let's say you set aside 15% of the company for early hires and then got a 20% dilution on your first round. After about four total rounds of funding with the same favorable terms, you’ll end up with about 35% of ownership. Because the value of your stock has increased too, this isn’t too bad. 

Now imagine if you had accepted a 30% dilution in the first round, and future investors strongarmed you into similar terms. You’d be left with a lot less – closer to 20%, in this case. The same logic applies to other clauses of your term sheet that you should be conservative with.

2. Be careful with post-money SAFEs

About a decade ago, most early-stage funding happened through priced equity rounds. Investors favored preferred shares, and having ownership. If not priced equity rounds, investors used convertible notes, which is a short-term debt converted into equity in the startup when the time is right. 

In the last five years, SAFEs have gradually taken over. This new funding instrument offers the same benefits as a convertible note—easier, faster, and cheaper to negotiate and implement than priced equity rounds— without monthly interests and a maturity date.

Initially, investors exclusively used pre-money SAFEs. This put investors at risk because any extra money raised during a round diluted the investors' participation. 

As early-stage investment rounds got bigger, post-money SAFEs were introduced. And guess who gets more equity dilution as the funding amount increases? That’s right: YOU. 

If you are going to raise funding with a post-money SAFE, you need to know exactly how much you want to raise. Every single extra dollar you raise will dilute your founder equity and that of shareholders who invested in prior rounds.

Dan already shared a founder's story about SAFEs and dilutions on his episode of the Latitud Podcast: 

"I had a deal recently with Kaszek — great founder, young founder, I think he's like 21-22, first-time founder, had gone through YC, and he was raising his first priced round. I think he was raising US$4-5M and had US$4-5M of SAFEs that had previously been raised and under fairly low terms. When we got to the actual conversion and showed him what the cap table looked like post-series A, he was decimated", said Dan. 

"(...) The poor guy ended up with probably 40% less equity than under normal circumstances he would have had. I see that a lot. In Latin American and developing markets you really have to be thoughtful about making sure each equity that you raise is modeled and valued appropriately."

A partial solution is to trade a radical approach for a step-by-step one when discussing your valuation cap. Have a strategy of growing/sliding caps. Raise as little capital as possible, and increase the valuation cap as you continue raising funds.

For example: instead of aiming for a $2,000,000 valuation at a US$200,000 round (10% dilution), aim for raising a first US$50,000 round with a US$2,000,000 valuation (2.5% dilution). After that is complete, raise another US$50,000, but with a US$4,000,000 valuation, reflecting your improvements over that time. 

This way, you can limit your dilution. But also be wary of complications in your cap table with many investors, and with high legal costs associated with multiple rounds.

3. Be stingy about pro-rata rights

Big funds typically have target ownerships, and that’s why they negotiate pro-rata rights. These rights give investors the power to maintain their initial level of ownership during future funding rounds.

Can you imagine what happens if all your investors get pro-rata rights? When existing investors maintain their ownership share of your company, the equity that will get diluted when new investors come on board is yours.

There are two things you can do to limit this risk. Firstly, don’t give pro-rata rights to everyone. Limit them to your lead investor and a few other big investors if needed. Secondly, try to make them expire after the next round, so you get more flexibility in the future.

4. Base your ESOP pool on data

Investors will typically ask for an ESOP (Employee Stock Ownership Plan) pool as part of the terms. That's because setting aside more stock options for future employees grants you access to better-skilled C-suite executives.

But there’s a catch. The equity that gets diluted is usually that of existing shareholders if positioned as a condition of the investment. A bigger ESOP pool is a massive win for new investors because it doesn’t affect their shares but increases their win potential. 

To get better ESOP terms, get your data together. Make a hiring plan for the positions you want to fill between this round and the next. A typical ESOP pool ranges between 10% and 20%, but you don't need to go that high. Research how much equity you’ll need to get these people on board. Share that number and explain you’ll review the pool in the next round.

ESOP pools are an excellent way to recapture some of your equity, by the way. If your company is doing well, you can ask for a founder refresh. This means a percentage of the ESOP pool can be allocated to the founders. Most likely, investors will ask for this to be vested (granted only with a waiting period) to make sure you keep growing the company for the next couple of years. 

5. Limit the equity you give to accelerators and advisors

It’s pretty typical for LatAm startups to participate in multiple accelerators—first locally, then internationally. Unfortunately, accelerators take on average 5-7% stakes in startups. 

You don’t have to be a maths genius to figure out how participating in a few programs before you even start raising seed funding could lead you to a lot of founder equity dilution.

Any advisors you consult might ask for stock options as well. These will typically be taken from your ESOP pool. Make sure you don’t empty your pool this way.

What if you're already too diluted?

When you go through multiple funding rounds, cap tables get quite complicated, especially if you have opted for growing/sliding caps. In that case, you’ll have a hard time understanding your equity position, even with cap table software like Carta and captable.io.

While everything with the company keeps going as planned, you don’t have too much to worry about. If you decide to pivot, however, and some co-founders or investors leave the table, things get messy—like, really messy.

The remaining founders might have about 10% of the company in hand. And they’ll be looking at more funding rounds that will further dilute their shares. At this point, raising money will be tough: investors will likely see your small ownership as a red flag, as they want your incentive as a founder to be high.

If you ever find yourself in this position, you’re better off with a fresh start

For more hands-on fundraising and startup advice, join Latitud, a community of high-caliber founders and mentors to support you on your journey: apply.latitud.com

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