Understanding How Dilution Affects You at a Startup

Posted on Oct 14, 2011 | 34 comments


This post originally appeared on TechCrunch. Dilution. Or as industry insiders call it, “taking a haircut.”

Everybody knows that when you raise money at a startup your ownership percentage of the company goes down. The goal is to have the value of the startup go up by enough that you own a smaller percentage of a much larger business and therefore your total personal value goes up.

The simplest way to think about this is: If you own 20% of a $2 million company your stake is worth $400,000. If you raise a new round venture capital (say $2.5 million at a $7.5 million pre-money valuation, which is a $10 million post-money) you get diluted by 25% (2.5m / 10m). So you own 15% of the new company but that 15% is now worth $1.5 million or a gain of $1.1 million.

But understanding how you’re likely to get diluted over time is a more difficult concept. And figuring out how much your equity may be worth over the course of a 5-year stint at a startup is even more complicated.

I’ve had to simplify a bit, but to make it easier to understand I’ve teamed up with Jess Bachman at Visual.ly. If you want to see a view of the power of their work check out this Steve Jobs infographic. I’m a huge believer in Info Graphics and the ability to create deeper understanding of complicated topics through visual means. As “Big Data” becomes more pervasive the power to visualize will become increasingly important.

And Jess is awesome at his trade. His personal blog with some great example is here.

So here is our crack at explaining the world of dilution to you. Let us know what you think. And if you want more goodness like this don’t forget to sign up to my newsletter and follow Jess on Twitter.  We’ll bring you some more goodness again. Let us know what topics you want us to break down for ya.

 

Listen, understanding the world of valuations and how equity gets split on a sale is a whole lot more complicated than the graphic depicts. I hope it gave you a flavor. If you want a deeper dive I shot some video on calculating ownership and dilution over time. And make sure to read VentureHacks.

Top image courtesy of Fotolia and the super generous Ryan Born (who of course, was born Ryan).

 

  • http://byJess.net Jess Bachman

    Thanks Mark, pleasure working with you.

  • Anonymous

    So, in a nutshell: fewer founders & less funding?

  • Anonymous

    Mark, great to the point post. Love the visual from
    Visual.ly!

    I was glad to see that you added to word “favorable” to the
    first example. However I think you might even have to do it for the second
    example. I have recently brought up funding (not started looking yet) to a
    couple of my advisors and the answer from them was the same – You will be diluted
    to less than 50% after seed!

    Obviously I was a bit taken back from that since I would
    literally fall right into your example on raised/post evaluation. However their
    arguments were (correctly) that I am no Kevin Rose or Sean Parker and only
    serial entrepreneurs with high exits will get good deals like that.

    I know it is difficult to get some hard data on this, but I honestly
    would love to see some info on startups that raised money recently that was
    started by entrepreneurs without prior exits, and who didn’t work on a big
    project for Facebook/Twitter/Google, and also didn’t go through an
    accelerator/incubator. Basically your more average but realistic startup ;).

  • http://www.octanenation.com Matt Beaubien

    Personally I found the infographic a bit hard to see how the situation changed for the founders over time so I created a simple graph of the Total Investment, Post Money, and Founder’s value. Have a look at it here: http://bit.ly/qO90k5

    You can see a amount of money going into the business but the founder value increasing at a slower rate due to dilution.

    To do a ‘proper’ analysis of whether or not to take money would require the founders to determine their expected value, which is simply (value of their stake) * (probability of success).

    With that said it’s an interesting and very important topic for all founders to truly reflect on.

  • http://www.desmo.org Stefan Portay

    This is such a great post tackling a tough subject! I’ll definitely be sharing this!

    Thanks again!

  • http://bothsidesofthetable.com msuster

    yes & yes. Unless you’re quite certain you have “a tiger by the tails” in which case raise more money but understand you’re probably leaving out other scenarios for an exit

  • http://www.alearningaday.com Rohan Rajiv

    VERY nicely done Jess :) 

  • http://www.alearningaday.com Rohan Rajiv

    LOVE the infographic. Thanks a lot! 

  • Anonymous

    This is exactly why every fundraise should be looked at as accelerant. If it can’t increase your rate of growth significantly then you are going to get hurt.

  • http://sisyph.us/ ErikSchwartz

    If all is going well why are you selling the company at the series C post money valuation?

  • James

    That’s the part I also don’t understand. Is this a realistic exit in the first place ?

  • Keith West

    A chilling graphic. And yet, every VC you hear open his mouth talks about the importance of the “team”, by which they usually seem to mean founders. Most say that they won’t even fund a solo founder. Seems like an expensive waste of equity to get a skill which almost certainly available much cheaper with a W-2 (even counting options). I’ve had co-founders in the past, with good and less good experiences. This time though I’m going it alone. The whole point of funding as I see it (in at least in my case) is to hire the people to do what needs to be done.

  • http://twitter.com/DanielSBowen Dan Bowen

    I think this article goes well with your thoughts about why we do this stuff…ie…money first and to save the world once we’ve achieved some level of financial freedom (all obvious references to passion aside).  I’ve read and watched a number of your interviews where you talk about achieving a specific financial goal and then building the next thing to leave your mark.  This dilution lesson is very helpful if you’re in that first stage trying to identify whether or not the financial homerun is even a possiblity after everyone cashes out (assuming you’re not on the space shuttle).

    If I hadn’t read through the majority of the info on your site, coupled with your personal stories that are painfully close to home (infographic in point), I could have been led to believe that you are baiting people into GRP with your kindness…it’s clear however that you really do love this stuff.  I applaud your candor, you are insightful, informative, painfully direct, and I find it all pretty refreshing.  In my first post to you I mentioned that I felt like I owed you a bottle of Glenmorangie…it will be in your office soon.  Thanks for continuing to educate us…

  • Michael Gnanakone

    So I think your trying to tel me to have only one co-founder and bootstrap my startup w/ no VC? I don’t know what tiger balls feel like so I’m kind of lost… 

  • Anonymous

    Great question,  Mogens. Our startup is early-embryonic, and we don’t have a track record of growing & exiting startups either.

    Mark: In light of the scenario of a $20k/year effective salary after all is said & done, is it normal for the founders to draw a (real) salary during this time? Even a small one?

  • http://freshfugu.com Martin Wawrusch

    Really good one, thank you. I struggled explaining this to potential hires for years and the pie on the napkin approach was always a stretch. Your info graphics is great, especially to illustrate that we founders are the poor bastards here :) 

    So it seems that flipping after an Angel round instead of going VC and perhaps have to do multiple rounds is the better strategy for most people, especially if you don’t have a shot at a 100 mil+ exit and have multiple equal founders?  
    For example exit as soon as you got product/market fit and traction like for example about.me? 

    @jessbachman:disqus  Great work with visual.ly, love your site.

  • Anonymous

    Mark and Jess,  The infographic is super useful.    I’ve been having difficulties helping my developer team understand the importance of minimizing team size and maximizing our few dollars so we hold on to as much as we can over time.  Keeping the team smart, fast, and small is an important part of that, and the graphic helps make that argument to a point. I’d love to see an infographic that helps visualize the impact of different funding models on revenue and expenses over time.  I know this may be unique to each business and the goals of the business but I know there are general principles that apply and it helps to be able to visualize general impacts.  Thanks for the great stuff.

  • http://twitter.com/davidsmuts David Smuts

    God help the poor founder who signed up to 1.5 liquidation preference or dividends or ratchets on milestones (which he will inevitably miss). And let’s not forget Mark…, assuming the company is sold for $50M we have to take off all the legal fees, auditor fees and various costs of the sale or exit etc.., before divvying up the remaining profit. Often a $50M sale can cost you $5+M just to complete the transaction! 

    For this reason I always reserve judgment (in regards to determining a CEO’s success) whenever I read about some CEO who sold his company for $100M. “Selling your company for $100M” and making $100M are two separate things! Founders may be surprised to know that many CEOs who sold their company for $100M+ often earned less than they would have as an accountant on an annualised basis after taking off the various costs of the sale and the affects of distribution, dividends, ratchets and liquidation preferences.

    Very good post Mark. Credit to you as a VC for being so transparent. Looking at the “realistic scenario” and net earnings per year it’s no surprise why so many seasoned founders leave the stressful world of Entrepreneurship behind to become VCs. These guys figured out the maths.

  • Anonymous

    Great graphic. Can it be customized for a specific deal to be used in negotiations and discussions?

  • http://www.SixthSenseLaw.com Mark Richardson VI

    Very good explanation.  I wrote an article on this subject a few years back, but it was short the great infographics!  This is very helpful to start-up clients.

  • http://twitter.com/PassOnSale PassOnSale

    Thanks, really value info. The image answered a lot of my questions. 

  • S.Lee

    Although it is a great article, I find it hard to read with the image or graphic being too large. I completely understand the purpose of having different graphic size illustrates the the size of monetary value, but it is just hard to read.

  • Anonymous

    Testing with twitter account

  • Swl

    Quick question about the math, excuse my ignorance. At the start of the post it mentions owning 20% of a 2M company (400k), then it says that a funding round occurs (2.5M for a 7.5M premoney Val). So is that the same company? If so, wouldn’t the founder own 20% of a 7.5m company just prior to funding. 20% of 7.5m is 1.5M, so in this example was any value created for the founder? Sorry about my confusion. I appreciate the remedial help!

  • Craig Salvay

    I often suggest the following to entrepreneurs:
    1. Get your company valuation to $1 million with ‘Friends & Family’ round.
    2. Retain about 71% after the first round, regardless of “pre-money” and “post-money” valuation.  If the concept has legs, it will attract the necessary capital at that level.
    3. In the second round, try to retain about 71% of your post-first-round 71% so that your “post-money” second round percentage remains just over 50%.
    Of course, this scenario is only possible for high-growth, high-tech businesses that attract high-risk capital to the table.  First-time entrepreneurs will have a hard time negotiating to end at a second-round percentage greater than 50%; but they should aim for that.
    Craig Salvay 111017

  • http://www.begun.ru/begun/collaboration/agents/detail.php?ID=3689 web promo

     Nice post and it would be great for everyone, Thanks a lot for spreading this information here.

  • http://twitter.com/HarryAvdVeen Harry A van der Veen

    The visualization definitely helped to get a better understanding of the entire picture. Great post!

  • http://petegrif.tumblr.com/ Pete Griffiths

    Yes

  • Jacob

    It can effect things positively and negatively. Thanks
    Jacob Evans,
    CEO, http://www.ppm.net

  • http://twitter.com/baswillems Sébastien Willems

    That 5-year average annual income doesn’t include the income founders have while working for the company. Although in most cases founders earn a shabby salary while they build the company, it still is cash that keeps them and their family alive. For entrepreneurs, those years are behind them and now they have capital of their own (as little as it might be). They started out with nothing, built something that resulted in more cash in the bank than they ever had and are now in the position to do it even better with the next company they want to build. 

    Seriously, the ‘annual average income’ part is just not relevant. 

  • http://www.marketing.fm Anonymous

    Great infographic and an important read.  The employee options take an even bigger roller coaster ride sometimes but its great to get this information out there.

  • http://twitter.com/to2 Trevor Owens

    Brilliant. One of the most valuable blog posts I’ve ever read. Thanks Mark.

  • Dannyjhaber

    Mark I need your help in an equity question for my startup.  Please email me at dannyjhaber@gmail.com

  • http://notesfromtheninjabunny.tumblr.com Emily Merkle

    Sorry to be late…
    Been tossing and turning on this one…

    I am not suited – nor do I want to be suited – to continue now that I have examined books & see ramp – have offer – how to be nice but careful not to burn a bridge (if I am wrong)