How do you deal with dilution?

 

good uglyOnce a venture has moved beyond friends and family money and convertible notes or SAFEs, the fundraising option is down to one method: selling equity in the company. And once you take that route you will need to deal with your and your teams’ ownership all being diluted, e.g. ownership in the venture will go down in direct proportion to the amount of money you raise. (The only exception being if you or your co-founders have enough capital to invest in the company alongside the VCs – rarely if ever the case.)

The Techcrunch article by Bernard Moon Dilution: The good, the bad and the ugly is highly recommended reading for those founders raising a Series A for the first time. Bernard Moon is co-founder and partner at SparkLabs Group, a network of accelerators and venture capital funds.

Bernard very helpfully provides the cap tables for three different valuation scenarios which I won’t reiterate here. What I will do is pull out some good advice from the article and add some of my own.

Number one is that most VCs insist on a 20% employee stock option pool. So everyone in the firm will take dilution from the pool immediately. Note that the venture takes this dilution, not the VCs!

Another key point for those who have raised money through convertible debt or a SAFE is that the cap on valuation from those instruments is NOT your company’s valuation for purposes of raising money by selling equity. So don’t get too focused on that valuation when negotiating your valuation with an institutional investor.

Secondly, as Bernard writes, “you need to create investor interest while generating the least amount of friction to quickly close your round.” Welcome to the world of tradeoffs – you’ll be making many as you build your company.

Founders are faced with the Goldilocks problem: if you raise too little money you may well run out of cash before getting your company to the important milestone of positive cash flow. You don’t want to be in that position. But you can also cause problems if you raise too much money. For one thing, you may have sold too much equity at a price much lower than it will be after you hit a major milestone or two. Companies, like people, tend to live up to their incomes, so too much cash is easily spent. Raising enough money to get to a major step up in valuation in your Series B financing round, plus a 20% contingency, should be your goal.

The rule of thumb is that you should raise enough capital to last between 12 and 18 months. Why? For two reasons: one, fund raising is very time intensive, especially for the CEO and is a major distraction for senior management. It also generates anxiety amongst the staff. (How much will I be diluted?) Secondly, your valuation on your series B financing is going to be based on your accomplishments and value added since your Series A. You need to give yourself enough time to hit meaningful milestones.

Your goal should be to have two or more term sheets. Competition drives valuation. If you have a hot startup there will be competition for your Series A. And sometimes T’s and C’s (terms and conditions) vary between investors. Be careful to analyze the terms of the investment and what preferences the investor expects to receive in addition to their equity ownership.

Keep in mind that the founders’ equity upon closing a Series A can go up if the Board later decides to award additional shares to the founder for exceptional performance.

Finally, it’s not all about valuation and percentage ownership. As I was taught by Alan Bufferd, treasurer of MIT and a two-time investor on the part of MIT in my startups, “Everybody’s money is green.” Meaning what value add does your investor bring to the table: Stellar reputation? A great network? Proven help in recruiting world class talent? Ability to syndicate deals with other top flight firms? A partner who will champion your firm far past the Series A closing? High marks from other founders who have taken investment from this firm?

Remember, a small slice of a very, very large pie is much preferable to a large slice of a tiny one! Your job is to bake a very, very large pie!

 

 

 

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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