Equity dilution is one of those subjects that always has people looking for a secret cheat sheet. Founders find themselves asking the question, “How can I prevent dilution?” And most experts would answer them by saying, “you can’t.”
But that’s only partially true. Equity dilution can actually be a smart move… or it can really screw you over. Founders can avoid making costly mistakes with their equity by understanding which terms affect stock dilution the most so they can recognize and avoid potentially pointless dilution.
Let’s go over a few basics before getting into the details of equity dilution terms.
Here’s what we’re going to talk about in this post. If you’re a more experienced founder, you can skip ahead using these links:
- What is Equity Dilution?
- Is Dilution a Bad Thing?
- Understanding The Value of Your Equity
- The Difference in Common Stock and Preferred Stock
- The 6 Terms that Affect Startup Dilution the Most
- How Does Equity Dilution Work?
- How to Prevent Equity Dilution
What is Equity Dilution?
At its core, equity dilution is the reduction of ownership as a result of new shareholders.
Dilution can occur when you raise a preferred round or when you grant stock options as compensation to employees. Dilution can also happen as the result of a convertible security, which is debt that converts to equity during a preferred round.
How Convertible Notes Affect Dilution
For the sake of this article, we’re going to focus on dilution as it results from raising funding during a preferred round, like a Series Seed or Series A.
Check out our webinar for a more in-depth look at startup dilution.
Is Dilution a Bad Thing?
Let’s clear up a common misconception before going any further. A lot of people think dilution is a bad thing. And sometimes it can be, but more often than not, dilution is just a necessary part of growth and not something to be afraid of so much as something to be prepared for.
Take a look at this question…
It’s a pretty simple answer right? $10 million is a lot better than $1 million. That example summarises why dilution doesn’t have to be a bad thing. Sometimes, it makes more sense to bring in new investments so you can expand your talent, business, and hopefully the value of your equity.
One more thing…
The idea that dilution is a bad thing is also related to the perception that investors are trying to shark you at every turn, which is the exception, not the rule.
In truth, investors want you to succeed and investment firms build their own business by cultivating relationships with founders and entrepreneurs. It would be short-sighted to purposefully take advantage of you.
That said, they’re investors. They are looking for ROI, which is why you need to walk into every interaction prepared to confidently compare term sheets and think through how a particular term will impact the value of your equity in advance.
We’re going to discuss how to prepare for dilution further down in this post. If the anticipation is killing you, skip to that section now.
Understanding The Value of Your Equity
Something else to keep in mind when thinking of how dilution works is to think about how your value is being diluted. It’s a common mistake to only consider how your ownership percentage will be affected by dilution. But what you should really be asking yourself is how your payout is being affected by dilution.
Certain terms will cause the monetary value of your shares to decrease. When you see these terms, what you’re really seeing is fewer dollars per share during a liquidity event:
- Liquidation Preference
- Participation Rights
- Cash Dividends
The following terms will cause a reduction in ownership percentage:
- Number of Shares
- Conversion Rate to Common Stock
- PIK Dividends
A drop in your ownership stake certainly plays a part in dilution long-term but is not the same thing as how dollars are distributed during a payout. (This goes back to owning a little bit of something very big.) Not to mention, with every dilution causing event, like a new round or issuing shares, your ownership stake will decrease.
It’s a subtle difference between the two, but necessary to understand if you want to be smart about your equity.
We also need to understand the roles of common and preferred stock in order to really understand how these terms impact equity dilution.
The Difference Between Common Stock and Preferred Stock
There are different types of stock: common and preferred. The most important differentiator is that preferred stock comes with certain rights that common stock does not have.
Because preferred stock usually comes with negotiated advantages, it is often only held by investors. Common stock, on the other hand, is usually given to founders and employees.
While it is the most routine scenario to issue preferred stock to investors and common to employees, it is not a rule. Preferred stock can be given to employees and common stock to investors. Issuing stock is a negotiation and therefore it is discretionary.
The terms set when issuing preferred stock are the terms that play the biggest role in diluting other shareholders.
That said, there’s a key nuance of preferred stock we need to review…
Preferred shareholders can negotiate certain terms that will either directly convert their shares into common stock or allow them to participate with common stock while keeping their other preferred rights.
But why would they want to convert from preferred to common in the first place?
Without terms that allow shareholders to participate in common stock, the value of their equity is essentially capped. For example, a preferred shareholder with a 1x liquidation preference and no other terms is going to receive 1x their investment during liquidity and nothing else.
In order to make a profit from their investment, that shareholder would need to go on to participate in common stock or set a higher liquidation preference. By converting to common stock, the full value of their shares will be realized, probably outpacing a higher liquidation preference. We’ll go more in-depth on dilution during a liquidity event a few paragraphs down.
Now that we’ve covered some basic concepts that will prove helpful, let’s get into the specific terms and what impact they’ll have on your equity.
The 6 Terms that Affect Startup Dilution the Most
When an investor hands you a term sheet, it will have certain negotiable levers listed in the form of individual terms. There are more terms on a term sheet than just what we’re going to cover in the space of this article. If you’d like to learn more about term sheets, read our article, “Term Sheets: The Definitive Guide for Entrepreneurs.”
Term 1) Number of Shares
The number of shares you have, out of the total shares that have been issued, makes up your ownership percentage. So, the fewer shares you hold, the less you own of the company. In that way, it’s clear why this term plays a big part in how much dilution you see on your cap table.
There are a few components to be aware of within granting shares including your valuation and your option pool.
Your company’s authorized share count is the legal limit of how many shares you can issue. If you want to change how many authorized shares you have, you have to amend your articles of incorporation, which costs time and money. For this reason, it’s important to use best practices from the beginning and set up your equity in a clean, scalable way. If you need support setting up your equity, Capshare can help you.
How Does a Valuation Affect Dilution?
Determining what percentage of the company an investor owns, and therefore how many shares they have, depends on two things: the company’s value and how much money is being invested. You’ll need to calculate your company’s pre-money and post-money valuation in order to know exactly how much dilution to expect.
For more on calculating your pre and post-money, check out this blog article.
Here’s an example of how a valuation will affect your stock dilution from our Dilution 101 Webinar:
In this example, you can see that doubling the pre-money valuation saves current shareholders nearly 12%. A larger pre-money valuation will help control dilution because new investments become smaller pieces of a larger pie.
How Do Option Pools Affect Dilution?
Often times, investors require companies to allocate shares in an option pool for future employees with stock-based compensation before their investment, meaning current shareholders would be diluted due to the creation of an option pool and the pending investment, while new investors would skirt dilution during that round.
Here’s what that would look like:
As you can see in this example, the founders diluted their ownership percentage to add an equity pool, resulting in allocating 16.67 percent of the company to participants of that equity pool. However, when investors come in, the founders and the equity pool are both diluted again, while the investors avoid dilution entirely.
The main takeaway from this term is that the number of shares you grant will immediately dilute your ownership stake.
Keep in mind that your ownership stake is not the same thing as the value of your equity. If I own 50 percent of nothing, I have a 50 percent ownership stake and nothing to show for it…
Term 2) Liquidation Preference
A liquidation preference gives shareholders first dibs during liquidity. It means that shareholders with a liquidation preference get their money before anyone else gets anything at all.
Typically, you’ll see a 1x liquidation preference, which guarantees investors will at least break even and receive their initial investment in full before common shareholders start participating in the distribution.
However, if you see a liquidation preference that multiplies the rate of return, for example 3x, then the shareholder would receive 3x their initial investment before other shareholders see a penny.
This can quickly snowball out of control and result in other shareholders, including other investors, walking away empty-handed.
Usually, investors will opt for a 1x liquidation preference and a 1x conversion rate to common. In that scenario, they would be guaranteed to get their money back (assuming the exit value is high enough) and then if the exit value is higher than 1x their investment, convert to common and start participating at their full ownership percentage.
Term 3) Rate of Conversion to Common
Just like it sounds, this term only applies when preferred stock is exchanged for common stock during a distribution event, like an exit. The term allows a shareholder to convert their shares to common at a multiplied rate, like 2 times what they initially held.
Even though preferred stock comes with certain negotiated advantages, it is sometimes more beneficial for an investor to forego their preferential stock and participate in common stock. If that’s the case, the shareholder will waive all their preferred rights.
Here’s a quick illustration of why this is such a powerful term and why it affects dilution so much…
Imagine shareholder A has 100 shares of preferred stock worth 10% of the company and a 1x liquidation preference. For the sake of easy math, let’s say the shares are worth 1 dollar a piece.
During liquidity, the shareholder would reach 100 dollars and stop participating. They got 1x their shares, but they didn’t receive 10% of the company.
Now, let’s say that shareholder A had negotiated a 1x liquidation preference and 2x conversion rate to common stock. Instead of walking away with 100 dollars, the shareholder would convert to common stock, and double his/her shares to 200 and thus 18.18% of the company.
So, as long as the liquidity event value is high enough, the investor is sure to make considerably more from his/her equity if they include a conversion to common rate in their term sheet.
Figuring out when it becomes beneficial to convert to common stock requires tricky math, and depending on what other terms you have in play, it gets messy very quickly. Capshare can do that math for you and model out exactly who would get what and why across different liquidation scenarios.
Term 4) Participation Rights and Caps
Participation rights can be… complex. They allow a shareholder to act like common stock while keeping all their other preferential terms.
Remember earlier we said preferred shareholders that wanted to convert to common had to waive their preferred stock rights once they convert? Well, not if they have participation rights. They will get the best of both worlds.
A participation right usually includes a cap, meaning they receive all the benefits of their preferred stock and then go on to participate as common stock with a threshold. A participation cap will often be 2x or even 3x the investment.
If they don’t have a cap, they’ll receive all the benefits of their preferred stock and then participate with common forever, diluting other shareholders’ equity value.
We’ll quickly walk through a scenario…
A shareholder with preferred stock could hold a 1x liquidation preference and participation rights with a 2x cap. That means the investor would break even and then start participating with common stock at their ownership percentage until they reach the value of 2 times their shares.
Suddenly, other shareholders are receiving significantly less value from their shares as this shareholder scoops up a large chunk of any distribution.
Term 5) Cumulative Dividends (PIKs and Cash)
There are two kinds of cumulative dividends, Paid in Kind (PIK) and cash. Both of these act as a form of interest with set terms for how much accrues and how that accrual method is calculated, like simple or compounded interest.
Some key things to know about cumulative dividends:
- Cumulative dividends paid in cash are the most common
- PIK cumulative dividends increase shares over time
- Both types of cumulative dividends are typically paid during a liquidation event
There are a few points there we need to expand on.
First, cumulative dividends will typically keep accruing until a liquidation event. That kind of pressure could be really hard on founders and shareholders because it incentivizes the company to sell as fast as possible to stop the clock.
Second, PIK dividends are paid in shares rather than cash. Depending on how you set up the accrual method and percentage, you can end up with broad ownership dilution by giving out shares to pay the dividends.
Figuring out how much a cumulative dividend will impact your cap table depends on your situation. At a fast-growing company, a cumulative dividend with an acceptable interest rate could be no big deal whereas an early stage startup could see painful dilution as a result of PIK dividends. There’s no one size fits all approach, which is why you’ve got to know the effects each term will have on your cap table before you agree.
Term 6) Anti-Dilution
While anti-dilution sounds like a good thing, it can actually be one of the most aggressive causes of widespread dilution. Anti-dilution acts as a cap, preventing shares from being diluted past a certain point.
Essentially, anti-dilution works to protect shareholders from future rounds of funding where the price per share is lower than the original price an investor paid, also known as a down round. During a down round, you can see your ownership percentage shrink dramatically.
There are several ways to incorporate an anti-dilution threshold. Probably the most common method would see past investors convert at the same price as new investors to keep their ownership percentage proportional. This is called a full ratchet clause.
Honestly, anti-dilution is a topic all its own, so we’re not going to go deeper into it in this post. You can read more about anti-dilution here.
How Does Equity Dilution Work?
Now that we’ve explored some of the most important terms surrounding startup dilution, let’s walk through some specific scenarios and compare the effects of the terms we just reviewed on a real-world cap table example.
How is Dilution Calculated During a Liquidity Event?
During a liquidity event, there’s quite a bit of complex math that goes into calculating dilution and equity distribution. A big part, maybe the biggest part, of that math is knowing at what point certain terms and shareholders participate in the distribution and to what end.
Capshare manages all the math for you and provides fully customizable reports so you can see what a liquidity event looks like in real time. Learn more now.
Here are some examples of a fictitious company’s liquidity event and “breakpoints.” Using Capshare, we created two versions of a cap table and changed the preferred shareholder terms, exit values and other details in order to compare how the terms impact dilution and payouts.
A breakpoint is a hurdle that must be met before certain shareholders participate. During an exit, each breakpoint has a corresponding exit value. For example, let’s say Company A sells for 2 million dollars. Series A preferred stock participates at the first breakpoint of 1.5 million dollars, meeting their liquidation preference. Afterward, common stock would be left to distribute the remaining 500,000 dollars at the second breakpoint of 2 million dollars.
How to Prevent Equity Dilution
Prevent. It’s an interesting word to use in this context, but it’s what people always ask.
As we said earlier in this post, dilution serves a purpose in growing your company so your equity’s value can grow too. Not only should dilution be expected, you really shouldn’t seek to stop dilution from happening.
What you do want to do is prevent broad, unwarranted or unfair dilution. Luckily, there are a few easy ways to achieve this.
Let’s start with best practices:
Organize Your Equity
The best defense is a good offense. Yes, it’s a cliche, but it’s cliche because it’s true. The first thing you should do is set your equity up in an organized, efficient way that manages all the bits and pieces so nothing gets lost. There are a few ways to do this, but we think Capshare is the best way.
Having an organized cap table has a lot of benefits, including seeing your dilution in real-time with real numbers. Read about all the benefits of a cloud-based cap table management system here.
Capshare offers services to clean up a cap table for you as well as consulting services for a more customized approach to your equity management. Contact our team if you’d like to take advantage of those services.
Get a Lawyer
While there is a lot you can do to evaluate term sheets with just Capshare, a lawyer can be invaluable. One really easy thing you can do is make sure your lawyer is with you when you negotiate your term sheet. They probably won’t hold your hand or go line by line, but they’ll point out where you should push back.
Consider the Following…
Have you ever been at a restaurant and seen something so delicious on someone else’s table that you ordered it too? It’s sort of the same when it comes to investors. Once you accept the terms of one investor, future investors are going to see what you agreed to once and they’ll want the same thing. So consider carefully the implications the present will have on the future.
The Best Way to Prevent Dilution: Plan Equity
Decisions in Advance
Wouldn’t it be nice if you could see the future?
While we may not be able to tell you about tall, dark strangers or lottery numbers, we can look into the future and forecast your equity dilution. And, it’s easy to do.
For years CFOs had to labor over Excel models trying to see how things would shake out. But Excel wasn’t designed to make effective and efficient models and ultimately, it just cost more time than it was worth.
That’s one of the reasons we developed scenario modeling tools. Scenario modeling tools will tell you in seconds exactly what’s going to happen to your equity. We can compare terms and show you how much dilution to expect and how much a shareholder will walk away with during an exit.
Scenario modeling tools work by copying your cap table and filling in customizable variables, allowing you to compare term sheets, option pools, new funding rounds, etc. without endangering the fidelity of your original cap table.
Each scenario generates a report with a visual breakdown by shareholder or security type. You can see breakpoints, waterfall analyses, and more.
The best part about scenario modeling tools is that they don’t require you to manually set up complex models. Just plug in the variables and immediately see what could happen.
It can’t be understated how important it is for Founders, CFOs and even investors to forecast their equity decisions, and it’s never been easier to do. If you’ve ever been the person asking, “How can I prevent dilution?” This tool is the easiest way to answer your question and keep you firmly in control of your equity.
Capshare’s Enterprise plan includes scenario modeling tools and a dedicated account manager to give you personalized support. If you want to learn more about Capshare’s scenario modeling tools, check out the webinar we made.