Dilution can be devastating, (if you don’t think so check scene from the Social Network below). You know that your share will dilute with fund raising or creation of an employee stock option pool but you need to know how to manage dilution.
What is stock dilution?
When you raise money your ownership goes down. In order to understand stock dilution in most simple way we can examine a case.
Assume that you are going for a funding round with 5m$ pre-money valuation (pre-money valuation is the value of your company before the funds raised) and you have 40% ownership with a value of 2M$. Let’s assume you have successfully found an investor that is willing to invest 3M$ in your start-up.
Your start-up will be worth 8M$ post-money (the 5M$ pre-money valuation plus 3M$ funds invested). Your shares would still be worth 2M$ after the investment but now you own 2M$ worth of shares in a 8M$ company which corresponds to 25%.
Your shares have been diluted from 40% to 25% in this scenario with an investment of 3M$ yet you still own 2M$ worth of shares.
Should you be afraid of dilution?
As pictured in above example stock dilution does not mean value of your stocks have gone down. If your pre-money valuation was accurate; value of your shares are still the same you should be able to calculate dilution of shares beforehand. However your ownership will determine the share of future growth you will get so you must be careful about how much money you want to raise in funding rounds and how much employee stock option you are allocating for your employees.
It might be tempting to raise as much as possible during a funding round but you must make sure that you are only raising money you need. Otherwise you are simply giving up share of your company for no good reason. Beware of accepting money that will leave you with less ownership of your company then you are comfortable with.
Conclusion
Always remember that raising money is not the goal; it’s a tool. You should be focusing on growing your company; although more money may be tempting during fund raising always calculate how it will affect you, never accept terms that you are not comfortable with.
As spoken wisely by former president of Y Combinator and CEO of OpenAI Sam Altman :
Remember that raising money is not success. Raising huge amounts of money early on is very rarely how companies win (though it is sometimes how companies lose). Be one of those companies that does a lot with a little, instead of a little with a lot. Resist the urge to seek validation by having a long list of impressive sounding investors.
https://www.ycombinator.com/library/4o-dilution