Dilution per round
A round of finance usually dictates dilution of 20-25 percent to all shareholders, including founders. A good rule of thumb is that investors are looking to gain that share in the company in return for their investment. This implies the valuation of the company based on a supply demand matrix. When negotiating an investment deal, consider upping the valuation to a point where it still reflects the true value of the company, is something the investors can be happy with in terms of returns performance potential, and yet accommodates this amount of dilution.
It often happens that a company ends up raising more than it intended. It is probably for the best because when planning ahead, having a cushion is a very good thing.
However, if by the end of that round, the dilution amounts to almost 40 percent, it could be that the company was undervalued and the founders significantly diluted. It would be harder for them to stay incentivised through additional rounds of finance and if the board of directors decides to accept that investment, it needs to consider what it means for the founding team in the long run. If there is no willingness, don’t take the money.
Balance of Power
When considering whether to accept additional investment from existing investors versus adding new investors onto the cap table, the founders should examine how the cap table forces are going to behave post investment. It is critical to have current investors participate in the round as it is a signal for new investors that they continue to believe in the company and are maintaining their position.
New investors provide a seal of approval to the financing round, balance out the cap table and the board of directors and allow for additional exposure to new ideas, new markets and new business. As the company matures, this balance of power in the board of directors will be significant when making executive decisions. Many times a single investor in the company holds much more than each of the founders or all the founders combined. This situation has to be managed so the founders do not feel loss of control and loss of incentive.
Ambivalence between exit outcomes
Founders that hold ten percent in the company and face yet another financing round might find themselves ambivalent between remaining with ten percent ownership in a company worth $50m and raising more capital to hold five percent in a company worth $100m.
This jump in valuation would entail working very hard with a similar outcome for the founder. Investors might have other considerations and would like to build large companies. When this conflict appears, the founders must receive additional incentive to be able to sustain. Should the solution require a change of management, there would be significant effort and shift in focus for the whole company. Founders are not always happy to step aside and make room for a professional CEO who can take the company forward. Not to mention that a rockstar CEO with a track record would require a significant equity stake to take the job to begin with, a step that may as well dilute everyone even further.
Secondary room for air
Some investors feel strongly against providing liquidity to the founders before an exit because they feel they would not be as “hungry” to make the company succeed. Others feel that this room for air would allow them the runway they need to sustain longer, as they don’t have to worry about making ends meet or pay a huge mortgage while their company is worth millions on paper. These days, more and more companies are encouraging secondary offerings not only for the founders but even for employees, to keep them incentivised and for the full compensation package to remain competitive in a market where engineers are expensive and talent highly valued.
Taking ownership into account can definitely benefit the founding team. Second and third time entrepreneurs are able to position themselves better in light of their experiences and their cap tables look completely different than first timers, maintaining a control position in the company well into growth stages. Together with your investors, you can consider ownership as an important parameter of an equity investment offer. Make sure to calculate a few steps ahead into future rounds to make the most of the road ahead. Good luck.
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