Imagine your startup hitting it big and selling for a fortune. Sounds fantastic, right? But here’s the twist: success doesn’t always translate to founders raking in the cash. Surprisingly, even when a startup thrives, some founders find themselves with less money than expected.
So why is this? It often boils down to a concept called “dilution.” Many founders overlook it when dealing with investors, which can be a costly mistake. If misunderstood, it can lead you to give away too much of your company and sacrifice control.
Here, we break down dilution and walk you through how it affects your finances during funding rounds. By the end, you’ll have a basic grasp of this vital concept. This will enable you to make smarter decisions about your investment journey.
What Is Dilution?
Dilution is a reduction of your percentage of ownership in the company. It’s a natural part of the startup journey. You need financial support to bring your big idea to life and watch it flourish. While fairy tale stories of instant success do exist, they are as rare as a golden egg. So, for many startups, getting outside funding is the ticket to making dreams come true when your own wallet isn’t quite big enough.
Here’s how dilution happens. You need money, so you go out and ask investors for it. You might do this multiple times—let’s say five times. Each time, you get the money you need by giving away some of your company’s shares. We talked about this in more detail in our article about common and preferred stock.
When you issue new shares to give them to investors, you increase the total number of shares in the company. Your own share stays the same, meaning your piece of the pie gets smaller. So, every time you successfully raise money at a funding round, your ownership percentage decreases. That’s what we mean by dilution.
How Does Valuation Relate to Dilution?
Let’s start with the definition first of all. Valuation indicates how much your company is worth. Think of it as a price tag attached to your startup by investors. They study the ins and outs of your project and decide how much it’s worth before giving you money. Valuation comes in two forms:
- Pre-money valuation refers to the value of your startup before receiving the investment.
- Post-money valuation is the value of your startup after receiving the investment. In short, it’s the sum of its pre-money valuation and the amount of investment.
Let’s see how valuation and its timing impact dilution.
Imagine you enter the round intending to raise $1 million (just to make the example simple). You succeed, and investors give it to you. So, how will this impact your ownership?
Pre-money valuation scenario
The investors give your startup a $4 million pre-money valuation. They provide the investment, and now you need to calculate how many shares you owe them. Before the investment, you had 4,000,000 shares. With a $4 million pre-money valuation, each share is worth $1. This means that in exchange for their $1 million, the investors receive 1,000,000 shares. So, at the end of the round, your startup has a total of 5,000,000 shares. Now let’s calculate the dilution:
(1,000,000 investors’ shares ÷ 5,000,000 total shares) x 100% = 20%
The investor owns 20% of the startup, which means a 20% dilution for you as the founder. You now own 80% of the ownership stock, even if the number of shares you own remains the same.
Post-money valuation scenario
The investors have appraised your startup at a post-money valuation of $5 million. Now, let’s determine the share price. You have 4,000,000 shares. But with a $5 million post-money valuation, this time, each share is worth $1.25. So, the investors receive 800,000 shares in exchange for their $1 million. This brings the total number of shares for your startup to 4,800,000. Have a look at the dilution:
(800,000 investors’ shares ÷ 4,800,000 total shares) x 100% = 16.7%
The investor’s ownership stake in the startup is 16.7%, resulting in a corresponding 16.7% reduction in your ownership as the founder. This way you’re saving 3.3% of your ownership from dilution compared to the first scenario.
The trick is to insist on post-money valuation whenever possible because this process will keep repeating itself. Dilution will occur, and your ownership stake will get smaller every time you secure new investment. You can’t avoid dilution entirely—it’s just part of the game—but you need to be smart about it and not give away too much of your company to investors.
A good rule of thumb for founders is to hold on to about 50% to 60% of your company after a Series A round. This way, you’ll retain some strategic control. If you end up losing too much ownership before hitting Series B, you could face challenges. This is because you’d have less freedom in strategic planning.
Bottom Line
Valuation and dilution are two sides of the same coin. As you move through funding rounds, your valuation climbs. But dilution also becomes more pronounced. Understanding how these two concepts relate is a must. It’s what lets you secure the funding you need for growth without giving up too much control.
At the Softeq Venture Studio, our mentors and experts cover these basics. We want to make sure our participants are well-versed in these startup concepts. This will make their future talks with investors much smoother.
