Founders have to hold onto as much of their company as possible. But of course, with every funding round, there is dilution (reduction of ownership), also. The cap table is the strategic forethought all along the way to make sure you are not unduly dilutive of original founders who need enough ownership to carry out their vision.
This is what founders can do to tackle this:
1. Control Valuation: The higher the pre-money valuation you receive for your company, the less dilution on the amount of capital raised. Develop solid traction, defined market opportunity and a strong team to negotiate a high valuation in raising.
Case Example - Brian Chesky and Joe Gebbia, co-founders of Airbnb: back in 2008, the duo secured their first funding rounds at a $600K pre-money valuation. They were able to raise the necessary funds without getting diluted a lot and they did it because of their strong pitch deck presentation and good focus on what disrupts the business model in hospitality industry.
2. Evaluation of Alternative Financing Instruments: Convertible notes or SAFE guarantees/contracts in place of priced rounds Instruments that let you avoid valuing your company until possibly a later funding round at a higher valuation and therefore less dilution.
Dropbox The Real-Life Case Example: Dropbox (early days) used convertible notes to raise funds. This lets them raise without a price and leaves room for them to further prove their concept and get a better Series A valuation.
3. Negotiate Share Classes - Create different types of shares with different voting rights and liquidation preferences. To preserve control, founders could issue super-voting shares that give them more votes per share than common stock issued to investors.
Example: In its IPO, Snap Inc. (Snapchat) sold the public non-voting Class S Stock that it gave to founders Evan Spiegel and Bobby Murphy allowing them to maintain powerful control over the company with a smaller ownership position.
4. Stock Option Pools: Allocating a reasonable portion of the company equity to an Employee Stock Option Pool (ESOP). This is important to promote talent retention by providing a win-win, incentive stock to employees as well as reducing future need for additional shares being issued (new fundraising) leading to minimal dilution of founders.
Example of Real-Life Case: Google has set aside 10% of its total equity in an ESOP at inception. This not only helped them attract the best talent but also ensured that employees had some skin in the game which, contributed to its long-term growth.
5. Bargain for Anti-Dilution Provisions: You should weigh asking for anti-dilution provisions, such as ratchets or weighted average anti-dilution clauses, in your financing contracts. Those can protect founders from dilution of ownership in case the valuation of the company falls with new funding rounds, forcing the investor to issue more shares at a lower price for later rounds.
A true world case in point: Some startups have managed altogether tight Anti-Dilution provisions, though this is far from a sure-fire proposition. Facebook's Series A funding included a provision for part of the acquisition deal at full ratchet anti-dilution protection for Mark Zuckerberg and Eduardo Saverin, Facebook's three founders.
6. Carefully stage your Financing: Determine how you plan to raise money. Raise just enough capital per stage Bootstrapping for as long as possible communicates resource allocation focus and can prolong dilution until a much higher valuation is possible.
Example: Jeff Bezos, founder of Amazon, bootstrapped the company for years and lived off customer revenue ales. This enabled them to avoid dilution and keep control of the company's direction during those critical early times.
Remember:
Have a startup financing lawyer review your cap table and the agreements you are entering into for financing.
Young companies should understand their views on ownership goals have an open dialogue with investors in the long-term vision and work with each other.
Instead, concentrate on building something tremendous. Of course, the best defence against dilution is good financial performance.
These strategies give the founders some direction about how to navigate the fundraising landscape while keeping a reasonably healthy piece of the pie and their hands firmly on the wheel.
Reading posts about Advanced strategies and considerations
This is an extension to the previous section on core dilution mitigation tactics where founders can take a deeper dive with advanced strategies and considerations series.
7. Redemption Rights: Founders can negotiate redemption rights that allow them to buy back the shares at specific points in time or scenarios (such as selling the company for less than a target valuation). Which provides some say in the ownership structure if a bad exit happens.
Real Life Case Example: Redemption Rights, are not common - but some founders get those rights. Take, for example, some of Elon Musk's Tesla shares as reported to include redemption rights that, if the company's stock price dropped below a certain threshold he could buy them back.
8. Utilize secondary sales: may consider allowing the transfer of founder and early investor shares to third parties (new buyers) without allowing such third parties any rights with respect to new company stock. The main benefit of this structure is it allows the founder to keep ownership of their company whilst giving some liquidity to early seed investors.
Example from real life: Many of the companies have come up with platforms for secondary sales like Carta. These are avenues for founders to approach likely buyers of available investor shares and minimize dilution.
9. Opt for Founder-Friendly Investors: Look for investors who are founder-friendly and invest in the long-term success of the company rather than those who want to see quick returns. For investors, such conditioning is likely to soften dilution terms and increase commitment to creating value alongside founders.
The Example full-case In Real Life: Andreessen Horowitz (a16z) is a venture capital between the most reputed for its founder-centric method. They invest in startups early on, and provide more than just funding: they create an environment where founders can keep control of the wheel.
10. How Dilution is Contextual: While dilution is a significant concern - so many other founders make noise about it, they forget the value that investors bring along with their capital Seasoned investors can provide invaluable advice, network connections and operational know-how that will probably leapfrog company development.
In practice: Impressive venture investor, Fred Wilson (not appreciative of bro-Grammers) made his early investment into online eyeglass seller Warby Parker. Although there may be some dilution vesting, Wilson's experience in building an e-commerce business was likely key to Warby Parker's growing so quickly.
11. Keep Lines of Communication Open: Founders should speak openly to investors about goals around having ownership and the future. This paves the way for less heavy-handed responses to potential conflicts around dilution terms that may arise in future negotiations.
Brian Acton, co-founder of WhatsApp: Fire the engineer in a nice way: Prioritize user privacy over short-term monetization Real Life Case Example This adamant stance, though perhaps detrimental to investor returns, resulted in Facebook picking up WhatsApp for a ridiculous 19 billion dollars. Fortunately, Acton was able to articulate a clear vision for how HE-qualified sales reps and inefficient territories could convert the business into something more predictable, so even with marginally diluted ownership he had a successful exit.
12. Dilution is not always a bad thing (strategic dilution is good) Connecting investors that add expertise, combined with the ability to find your company new sources of growth and rapidly increase its valuation.
A real-life case example: Slack (the workplace communication platform): Raised multiple rounds of funds which eventually diluted the founders. But with the capital and know-how of investors like Andreessen Horowitz (a16z), Slack was able to scale quickly and go public very successfully.
While there are some tactical techniques to reduce over-dilution, here are five advanced aspects that every founder should understand in order to masterfully manage their cap table.
13. Simulate (Dilution Modeling and Scenario Planning): Use cap table modelling tools to simulate multiple scenarios of what fundraising will potentially do to the company's ownership percentages. Founders can then understand the top line, and topline on the tradeoff between dilution and capital raised before they even walk into a negotiation.
While we do not store the exact commands, Capable manages our table, and this is what the cap table looks like in practice for a few of our most successful companies. Exponential companies with equity up to their eyes;) - (Software as a Service) Cloud software providers: Carta & Equity Zen *Side note: what amazing sponsors to have?! They let founders input different fundraising scenarios (valuation, amount raised) and show how much of the company would be sold to the investor so that they can make an informed decision.
14. Dilution-Runway: Striking the right balance between minimizing dilution while ensuring enough capital to reach key milestones/goals. Even with minimal dilution, if the company raises too little capital, it may not allow the company to grow and fulfil its potential.
Model Example: Door Dash, for example, a food delivery marketplace wanted to raise less capital so set very competitive terms upfront but ultimately persuaded the market to provide more money at a higher valuation meanwhile, digging its yield hole even deeper! It gave us enough of a runway to really blow into scaling hard and keep up the good fight in a very noisy and competitive marketplace.
15. An example of a common mistake is too many eggs in one basket when it comes to VCs. 7 max per investor and work very hard to have them come from different funds (the same applies to angels). No one investor owns too much, and only a small portion of the capital required to exercise control resides in any one set of hands.
Practical example: Airbnb received investments from different kinds of investors as they were growing (this was mentioned in the previous paragraph). Demographic diversification insulated them from the sway of a single investor, and the control over strategic decisions this afforded.
16. Founder Vesting with Cliff periods: Use founder vesting for all founders that have a cliff period applied. A vesting schedule locks in a team with the vision for some period of time. Cliff: A cliff period causes some of the shares held by founders to be vested at a later date, making them even more incentivized to stick with the project long-term.
Example: Most founders have a 4-year with 1-year cliff vesting schedule. That way a founder wouldn't own all of their shares until four years, with the first 25% vesting at one year (assuming a one-year cliff).
17. Record Your Cap Table Accurately - Record everything pertaining to equity issuances, option grants, and ownership changes with precision. Having a clean and accurate cap table is important for transparent investor communication and later fundraising and M&A.
Real World Example: Miscongruent cap tables have exploded in the face of several terribly high-profile startups. That kind of nonsense can largely be avoided on the front end if clear records are maintained, which also engenders trust among stakeholders.
18. Gain Access to Legal and Financial Know-How: Talk with startup financing attorneys and financial advisors familiar with venture capital transactions. Their experience can be the extra hand founders need to man oeuvre meticulously through the maze of complex legal and financial fundraising implications, keeping their best interests in mind.
Real-World Examples: Some law firms and many investment banks specialize in helping startups. Founders should lean on these professionals and make sure they are well aware of the legal and financial considerations when it comes to different financing instruments.
19. Develop Long-Term Vision and Exit Strategy Define how you want to run the company in this series of workshops, and what the exit might be down the line i.e. do they plan to sell it off to another company or take it public? This clarity makes the founders able to decide what level of ownership they need to set up in order for them can efficiently pass the path.
Real-World Example: Some founders - Elon Musk of Tesla comes to mind - want to build durable, autonomous companies until they grow into the marketplace; others - probably something like a possible acquisition from a bigger player. It helps founders make better decisions on dilution targeting what they want to achieve.
20. DOES YOUR DILUTION DEFENSIVE MEASURE BUILD VALUE? At the end of the day, the only way to protect yourself against dilution is to grow your company into something people want to own. To be sure, a company that can demonstrate a plausible path to profitability will almost always receive more favourable terms than one being handed the keys to a money-losing operation.
Just those advanced considerations and a long-term plan for the founders in order to navigate the fundraising landscape, not just blindly raise money. If it helps, dilution is a sign that your startup is growing. The challenge now is to control it and guide it more gracefully, with the resulting resources, people and partnerships helping the company reach its maximum level of achievement.
Conclusion:
For founders, managing dilution is pretty much a game of whack-a-mole. So, founders looking to maximize their opportunity and vision for controlling destiny and creation of long-term value should consider in advance the different types of strategies they can use. Keep in mind the best-case scenario is not merely reducing dilution, but getting the right investors and resources needed to move your R into a successful exit or life-long independent growth.
Comments