As a start-up founder, you need funds to grow and sustain the start-up. Hence, you plan to go on the next funding round. Considering that most start-ups do not have the readymade configuration to attract loan financing, the safer bet is equity financing. in that instance, what happens to your ownership stake and that of other early investors?
The downside to bringing more equity investments into startups is that it leads to a dilution of the equity of the founders and early investors. The more you give out equity (shares) of the company to investors, the less the proportion of the ownership stake retained by the founders and early investors. Simply put, Dilution is the reduction of the proportion of the equity of existing shareholders of the company (founders and investors) when the company issues more shares to new investors.
To understand dilution better, imagine a cake. The cake represents 'equity/ownership' in the company. If before the issuance of new shares, there are four shareholders in the company, the equity of each shareholder i.e. their share/slice of the cake will obviously be larger. But introduce two more people to share in that same cake, then the share of the earlier four people will subsequently decrease. That is the dilution of equity; the more the shareholders, the lesser the equity 'cake' of shareholders.
Dilution is almost unavoidable in startups since startups finance their growth by conducting several rounds of fundraising – Pre-seed, Seed, Series A, B, C, and later growth rounds. However, founders and early investors alike must be careful while raising funds to drive the project forward without losing control of the company.
Founders have dilution rights. They have the right to issue more shares and increase the capital of the start-up for the overall growth and development of the startup. However, existing shareholders naturally frown upon the issuance of additional shares since it leads to them getting a smaller slice of the 'cake'.
How can founders balance this right with their own right to ownership and early investors' right to equity and the need to raise capital for the start-up?
- Founders should determine the right amount of funds to raise. If you raise too much, you could give away an unduly large portion of your company. If you raise too little, you risk running out of cash before you achieve the set goals and you may find yourself running back to investors again. Also, identifying the proper amount of investment is important to avoid giving away too much of the founders' equity or negatively affecting the company's management.
- Founders can also choose a different funding route such as loans from banks, grants, some crowdfunding options, etc. By entering into certain clauses in the agreement with investors such as 'Dilution Protection Clause', 'Right of First Offer/Pre-emptive Right', 'Share Repurchase Programs' 'Founders' Restricted Rights', etc
. These clauses may however be disadvantageous to founders as they can prevent new investors from coming in. Founders can also protect themselves by giving these rights to major investors while limiting the extent of the exercise of these rights.
Conclusion
It should be noted that the dilution of the equity of the start-up is not all that bad. It has both advantages and disadvantages. Equity dilution may lead to a decrease in ownership stake and voting rights of the members of the company, however, investments mean more capital which if used properly, can contribute to the growth and development of the company thereby leading to the increase in the value of shares held by each member. Albeit presenting the founders and early investors with increased value for their reduced equity ratio.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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