Dilution: a 4-letter word for founders


Like it or not, virtually all tech startup founders will face dilution, the erosion of the percentage ownership in the venture they founded due to having to sell off their equity to finance the venture.

The article Dilution: The good, the bad and the ugly by Bernard Moon is a recommended tutorial for founders before you begin the process of raising capital. Keep in mind the source, Bernard is a VC at SparkLabs Group. If you want the VC perspective on dilution for founders their experience of investing in more than 230 companies is well worth reviewing.

For those of you not needing Bernard’s math through possible seed rounds to how future rounds dilute your ownership, I’m going to just highlight some words of wisdom to keep in mind regarding valuation, perhaps the most contentious issue both for founders   and investors (it’s a zero-sum game). While Bernard does a good job of defining a Good Series B (excellent execution) versus a Bad Series B (poor execution or mismanagement; product too early or too late; longer than projected sales cycles or market forces outside the founders’ control) he avoids the nightmare scenario I’ve posted about previously: asKryptonite for founders – the down round. 

As noted previously, trying to predict revenues for a startup is exceedingly difficult. But you should know your operating costs and be able to predict them with a reasonable degree of certainty, especially fixed versus variable costs. Typically founders are too optimistic and underestimate both the time and funding to ship their first product and to generate customer revenues. No matter how much contingency you build into your numbers things will just cost more and take longer – that’s just the way it is.

But there are two things you need to focus on in your projections:

  1. How much capital do you need to last 12 – 18 months?
  2. Will this amount enable you to hit the milestones needed to raise your next round?

Fund raising is extremely resource-intensive for the CEO pitching innumerable investors, so I’d err on the side of raising enough capital for 18 months, even if that results in somewhat more dilution. If you fall short of your projections, be prepared to answer these investor questions:

  1. Did you overestimate your sales’ ability?
  2. Was your capital efficiency significantly lower than projected?
  3. Is there really a large (and growing) market for your product?
  4. What mistakes did you make? What should you have done differently?

Investors are looking for founders who learn from their mistakes and use that learning to course correct. Humility is in store if your falling short is due to mismanagement or failure to execute.

There are two ways to gain a reasonable valuation and avoid undue dilution:

  1. Execute on your plan – hitting major milestones
  2. Competition generates value – have at least two term sheets

Here’s a great quote from Bernard:

Your goal is to create investor interest from multiple firms while generating the least amount of friction to quickly close your round. It might be a difficult balance between knowing your value but respecting what investors are looking for, but don’t kill your fundraising efforts by not being flexible on valuation. Remember, it’s not all about the money and your ownership percentage. If one of our portfolio companies had a term sheet for a $10 million pre-money valuation from an unknown family office or an $8 million pre-money valuation from a top-tier venture capital firm, we would tell them to take the lesser valuation, even if it’s a smaller gain on our books.

Having raised multiple rounds for VC-backed companies, I can attest the wisdom of Bernard’s words. But there are a few things I would add. First of all, know whether your first investor has deep pockets and is prepared to participate on future rounds if you hit your milestones. Angels and strategic investors may not. It’s not a good signal for new investors if institutional investors don’t participate in future rounds – you better have a very good reason. There are other ways to raise money, such as venture lending and warrants, that may work for you depending on if you have a capital intensive business with hard assets. Even if you don’t hire a full-time CFO I highly recommend you have the help of an experienced CFO to help you prepare your financials (and determine concomitant dilution!) for various scenarios. The return on investment in paying a savvy CFO can be 1,000X or more. When playing with VCs you want to try to level the playing field as much as possible. Your Board of Directors should have experience raising venture capital and be able to provide not just contacts, but valuable perspective and insight on the fund-raising process.

Finally, be careful to manage the expectations of the senior team and anyone else with options or restricted stock. They are all going to expect a step-up in your next round of financing – in fact they are counting on it to get them on the road to building their personal wealth. Much  better to under-promise and over-deliver.

Author: Mentorphile

Mentor, coach, and advisor to entrepreneurs, small businesses, and non-profit organizations. General manager with significant experience in both for-profit and non-profit organizations. Focus on media and information. On founding team of four venture-backed companies. Currently Chairman of Popsleuth, Inc., maker of the Endorfyn app for keeping fans updated on new stuff from their favorite artists.

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