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THE PROBLEM OF DILUTION
Most founders start out owning their company.
But to grow as quickly as possible, you’ll need investment, and to secure the capital you’ll need, your investors will want to own a part of your company.
The faster you grow, the greater your burn rate becomes, and the more capital you’ll need. You move from pre-Seed to Seed to Series A, but with every cash injection, you’re forced to give up another slice of your company. Offer too little, and the investment dries up — offer too much, and you’ll soon find yourself without a share in your own company.
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ANTI-DILUTION PRACTICES
This apparent horror story leads many founders to take staunch anti-dilution measures. But dilution serves a purpose: to attract skilled people and resources to your startup.
Whether it’s incentivizing a respected VC with a sizeable ownership stake, or luring top talent with an options pool, offering equity is beneficial to your startup, and attempting to hold on to as much equity as possible could limit your growth. Taken to extreme, anti-dilution practices could leave you as the majority shareholder of a worthless company.
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PRE-MONEY AND POST-MONEY VALUATION
Let’s assume both you and your investor have valued your early-stage startup at $100,000. Your investor is willing to contribute $25,000 to fund the growth of your company. How much equity should they get?
- If that $100,000 is a pre-money valuation, the company is valued at $100,000 before the investment. That means that the angel’s investment actually serves to increase the value of the company to $125,000, reducing their share to 20% and increasing yours to 80%.
- In both instances you’ve gained the capital you need to grow, as well as the expertise of a seasoned angel.
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EQUITY AND VALUATION
The only real valuation of a company is whatever someone is willing to pay for it, and a VC will pay huge amounts if they think you’ll be worth a whole lot more in the future.
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THE EQUITY EQUATION
Investment decisions can become incredibly complicated, and in the case of successful startups, minute changes to ownership stakes can equate to millions of dollars. Thankfully, there’s a simple rule of thumb we can use to work out whether or not we think an investment opportunity is worthwhile.
An investment deal is worthwhile if you believe the deal will increase the value of your shares in the long-term by more than it reduced it in the short-term.
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