How to manage excessive equity dilution
Equity dilution is often unavoidable and, for most startups, just a regular part of the business. However, dilution can easily become excessive if left unchecked, causing long-term unintended consequences.
In this article, we’ll go through what equity dilution means for startups, its consequences, and how you can mitigate it.
What is equity dilution?
Equity dilution refers to the reduction of ownership percentage held by shareholders of a company. At the early stage of funding, equity is your best option to attract investors. After the initial division, any new shares are known as secondary offerings to new shareholders.
However, you must remember that no matter how much capital increases or decreases or share buybacks may occur, ownership in any company is capped at 100%. This means that each new shareholder that comes on board will inevitably reduce—or dilute—the ownership held by existing shareholders.
Picture a startup that starts out with two founders, each with an equal 50% ownership stake. If they choose to bring an investor with a 20% share on board, they’ll need to give up some of their stock to make room. Both founders will still retain the majority, but this dilutes their ownership in the company to 80%. That percentage decreases if more shareholders are brought on.
That said, dilution is not strictly a negative thing. Dilution is one of the most common and viable ways to raise funds to grow your business. It’s also a good way to increase your company's value and stimulate gross income. If you use the funds productively and are smart about your equity division, dilution shouldn’t be a concern. It’s only when it becomes excessive, it becomes a problem for your startup.
What are the consequences of excessive equity dilution?
So now that we understand what dilution is, let’s talk about what happens if you don’t keep an eye on your equity and end up over-diluting.
- Decreased founders’ ownership and stake in the startup
Dilution affects the ownership of all stakeholders, including the founders. This can cause founders to lose control of the startup’s direction and voting power if their share drops below 50%. - Reduced equity stake value
If the total value of your startup hasn’t increased but the number of outstanding shares has, each share will be worth less than before. - Difficulty in raising additional capital in the future
Investors are less likely to invest if you’ve already diluted your shareholders significantly, as it means lower earnings per share compared to a startup with less dilution. - Creates tension among shareholders
As their ownership percentages reduce, shareholders may feel that their stake in the startup is devalued or their voting rights are affected.
How can you effectively manage your equity dilution?
Again, dilution is neither good nor bad. The key is managing it effectively, so it doesn’t lead to over-dilution.
Here are some tips to consider when managing equity dilution:
Take advantage of your cap table
Your cap table is your primary reference for any equity management. A basic cap table lists all your stakeholders and how much stock they own in relation to the overall ownership.
For greater efficiency, use a cap table management tool that includes features to help you proactively manage and predict future dilution. Equity management software breaks down possible scenarios that may occur after financing rounds, allowing you to compare ownership before and after rounds, so you’ll never be caught off-guard by excessive dilution.
Additionally, you should perform annual health checks and audits on your cap table. A great deal can change over six months or a year, but many startups forget to update their cap tables accordingly.
Conducting a yearly audit before a financial round will help you identify pitfalls and proactively address your equity division. It’ll also help you set your equity dilution for the next round. While this can be done on your own, consider working with a third party to help you with your audit. Working with an expert will save you time and money, and can guide you on best practices.
Consider using post-money SAFEs
Post-money SAFEs are a popular alternative to equity in early-stage fundraising. Compared to pre-money SAFEs, post-money SAFEs place dilution entirely on founders, allowing you control over your equity division. If you plan your fundraising and execute it well while keeping an eye on how many SAFEs you’re planning to raise simultaneously, there shouldn’t be dilution risk from post-money SAFE investment.
Be prepared for anti-dilution provisions
Anti-dilution provisions are clauses built into stocks to help protect investors from excessive dilution during down rounds. Usually requested by investors from the seed stage and onwards, these provisions grant investors the right to receive additional shares for free. They exist to protect investor interests, so prepare for such clauses ahead of time so you won’t be caught by surprise.
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