Startups typically have three broad ways of funding their companies. They are incubators/accelerators, angel investors, and venture capitalists (institutional investor). Generally, Incubators and Accelerators help the start-up team to set-up the company, and shape the start-up’s Go-To-Market strategy. This article is limited only to explain how the equity dilution works and won’t get into the details of valuations of start-ups.
The typical amount of money different investors pump in and the equity they take is as follows.
Understanding Equity Dilution with an Example
Let us take a start-up named XYZ Labs, and we shall walk through how the equity of the founders and the early investors gets diluted as the company goes through various rounds of investment. For the sake of simplicity, lets say the company has gone through an Angel round and one VC round (Series-A). Let’s say the angel investor took 20%, and the venture capitalist took 25% of the company for $N and $M post-valuations respectively. Let’s see how the equity gets diluted.
In any round of investment, if an investor is taking x% of equity, then the equity of all the existing equity holders will come down by x%. So, if I say y% goes down by x%, then the calculation is: y%*(100-x)% Or y%*(100-x)/100
Let’s start with Founders of XYZ Labs holding 100% of the company, and having a first angel round of 20% for $N valuation.
Let’s say the angel round is followed up by a Series-A round of 25% and $M valuation.
So, as mentioned above, at each stage of investment, the equity of the earlier investors or founders (equity holders) will get diluted. But, with higher valuations in every round, the diluted equity will have more value than in the previous round. Also, typically in Series-A there will be an additional 12.5% of Employee Stock Option Pool (ESOP) that is to be allocated. I haven’t considered ESOP in the above example to keep things simple.
The typical equity dilution at various rounds of investment looks as follows.
So, how does it happen in practice?
In practice, your earlier investors won’t like their equity to be diluted too much in the further round of investment.So, they would like to put some cap on the dilution.
The other important thing to notice is – the type of equity that the investors and founders hold is different. Lets understand that with an example. Let’s say the company XYZ Labs is being acquired by some other major company ABC Labs. So, will all the equity holders of XYZ Labs be paid at once? The answer is No. Typically, the order of payouts is as follows:
1. You first clear out any debts that XYZ Labs owes to any banks or other investors.
2. You then start paying out the equity holders in the following order:
a. Preferred Stock
b. Common Stock
The stock that the founders hold is called Common Stock. This has the least priority during payouts in case of bankruptcy, mergers & acquisitions, etc. As the investor would want to have an early and safe exit, the investors’ stock comes with certain preferences over the commonly held stock, and it is called Preferred Stock. Preferred Stock could have preferences such as conditions on future dilution, priority during payouts, option of investing in future rounds, etc. Additionally, preferred stock can also be converted into common stock to maximize investors’ returns. Also, since debt is payed before equity during payout, some investors will give you money in the form of debt (debt note) and not in the form of equity. Because investors know that debt has the highest priority during the time of payout, and hence they can have the earliest exit .
Now, you see that not all of us in the company are equal, and not all money is equal. But, remember that investors are putting their money on you at early stages and are taking high risk. So, it is justifiable for them to look for a safe and early exit with maximum return. As an entrepreneur, you will hear many terms such as convertible debt, participating preferred stock, etc. These are various payment preferences for the investors to have maximum return, and a safe and early exit under various situations of bankruptcy, mergers and acquisitions, or dividend payouts.
If you’re interested to know more about the start-up terms, please refer to the below link to a Forbes post.
For more details on common stock and preferred stock, refer to this article.
Hope you found this post useful. Thank you.