Equity dilution works when the same pie is divided among more people. The Founder of a company starts by owning all the shares representing ownership of the company. Over time, other people receive pieces of equity in exchange for work (employee stock options), money (seed, angel, and venture investors), services (attorneys, directors, etc.) Because the total percentage of equity will always equal exactly 100%, every time anyone gets another piece, by definition it "dilutes" all of the previous equity holders. Therefore, to avoid dilution to its existing equity holders, all a company has to do is not hire any more employees who get options, or take any more money from investors. “A small piece of a big pie is better than a large piece of a small pie” – This quote is thrown by every investor in the town to every possible first-time founder raising capital. Every time you get funding, you give up a piece of your company. The more funding you get, the more company you give up. That ‘piece of company’ is ‘equity.’ Everyone you give it to becomes a co-owner of your company. Smart entrepreneurs realize that it’s better to have 10% of the equity in a $5 million business than 51% of a $1 million business. And in giving up a great degree of control, a founder often receives immense financial and non-financial resources in return. It is very simple English to understand. Ask the founder a little deeper on it they fumble on their equity split understanding. Here I am looking to deconstruct the statement by putting real math around it.
- Stage 1 (Early Stage – Inception)
- Founders equity = 100%
- Valuation of the Startup = Unknown?
- Founders Wealth = Unknown?
At this stage everything about the startup is unknown hence there is no definitive number that can be associated with the founder's wealth
- Stage 2 (Seed Stage – Initial Revenues)
- Founders equity = 100%
- Valuation of the Startup = Unknown?
- Founders Wealth = Profits from the revenues
At this stage, the startup has revenues but has not raised capital from outside hence the founder’s wealth is equivalent to the profits of the company.
- Stage 3 (Seed Stage – Funded )
- Founders equity = 75%
- Valuation of the Startup = 12 Crore
- Founders Wealth = 9 Crore
At this stage company now has a third-party interest and hence company valuation has been determined. The investor gets 25% of the company by investing capital into the company. At this stage, new shares are issued and the size of the pie is getting bigger. No the shares of the founders remain the same but the % of equity holding decreased. The founder’s equity now has a valuation on paper.
- Stage 4 (Series A – Funded)
- Founders Equity = 55%
- Valuation of the Startup = 70 Crore
- Founders Wealth = 38.50 Crore
At this stage, the new investor joins the equity cap table. A new set of fresh shares are issued to new investors in lieu of their capital investments. The pie is now getting bigger. No shares with the founders remain the same but their % equity ownership in the company decreases.
- Stage N where multiple rounds have been raised by the startup-like Series B, C, D ....... & now it’s time for an IPO or an M&A
- Founders Equity = 20%
- Valuation of the Startup = 500 Crore
- Founders Wealth = 100 Crore
Fast forward if the company is doing well and has done multiple rounds of fundraising the pie has got even bigger and the wealth of the founder has equally grown while their equity % ownership has reduced considerably. Let’s run through the Google story which is in a public forum. In classic tech startup fashion, Larry Page and Sergey Brin founded Google in a friend's garage. Read here -
The basic idea behind equity is the splitting of a pie. When you start something, your pie is really small. You have a 100% of a really small, bite-size pie. When you take outside investment and your company grows, your pie becomes bigger. Your slice of the bigger pie will be bigger than your initial bite-size pie. When Google went public, Larry and Sergey had about 15% of the pie, each. But that 15% was a small slice of a really big pie.
