Managing equity dilution: 5 mistakes to avoid
Great success—your start-up has just received a huge offer of new funds from a venture capital (VC) fund. Time to break open the champagne, right?
Not so fast. Have you asked yourself how the new funds will dilute your ownership stake? Do you have the capacity to use the cash to grow your business? Will share price and enterprise value grow enough to offset your equity dilution? Did you even need so much money at this stage in your business growth?
Entrepreneurs spend a lot of time thinking about how to find money to grow their business. But many fail to adequately consider how new rounds of financing can impact their ownership stake and business planning.
Equity dilution can be tricky to manage
Dilution is what happens when an ownership stake in a company is reduced because of a new share issue or the exercise of stock options.
Whenever a company issues new shares, it translates into a smaller piece of ownership for existing stockholders. This, in turn, means a smaller piece of the proceeds if the business is sold.
Dilution is often inevitable in growing companies. Injections of capital may be vital to monetize a new technology or product, realize sustainable growth and achieve a favourable exit.
But neglecting to manage equity dilution carefully can lead to reduced control over the company and less to show for the entrepreneur’s innovation and hard work. To limit equity dilution, avoid these five common mistakes when raising capital in your business.
1. Assuming bigger is better
Bringing in more funds often seems like a mark of success and the key to growth in early-stage companies. But it’s important to think realistically about how much money you will need to build your business at various stages of its growth.
A large influx of cash could help your company grow, but you may not have the capacity to put it all to efficient use and it may divert you from your business strategy. The result over multiple funding rounds could be significant dilution.
The key is to find the right balance between dilution and growing your company’s value.
2. Forgetting your cap table
A capitalization table is a table that shows the number of shares and percentage of ownership of all shareholders in a business. Many entrepreneurs look at their cap table only as an afterthought when raising new funds. But a cap table can be a very useful tool when managing your ownership of a growing company.
You can use a cap table to model how various funding options will dilute the stake of existing shareholders and profits per share. You can also use a cap table to model the impact of a succession of future funding rounds as part of your overall plans for the business and possible exit scenarios.
Example of a cap table
This example demonstrates how complicated cap tables can get with founders, a new CEO, Seed and Series A investors.
Here, the entrepreneur is modelling a $2.5-million round of financing. The company’s valuation before the new round of equity financing (pre-money) is $12.3 million, while the valuation after the new equity (post-money) is $16.85 million. Every share is worth one dollar.
ABC Co. was founded by a team of entrepreneurs. Co-founder A, who stayed on as chief technology officer, was awarded 500,000 new shares in the new round of financing to limit his dilution. In this way, even though his ownership percentage diminished by 13 percentage points, the value of his holdings increased by $500,000. Meanwhile, co-founder B, who left the company, has seen his share of ownership decrease, while the value of his holdings has remained the same because of the increase in total company value.
The CEO and venture investors bought preferred shares. Preferred shareholders stand ahead of common shareholders in the payment of dividends, and they have a priority claim to assets if the company is liquidated or sold.
3. Neglecting to work on your business
Having a clear understanding of your business strategy and potential upside is critical to pitching your company to investors in a way that minimizes dilution. Many founders think they’ll be the next Google, but selling your vision to investors requires realistic numbers and a well-thought-out business plan. A compelling pitch could attract interest from competing investors, which should give you more leverage to potentially raise more money, get a better valuation and reduce dilution.
It’s also important not to squander the funds you raise. The goal is to use the cash to strategically and efficiently build your business, revenues and profits. That in turn should boost the value of your company to offset dilution.
4. Ignoring investors’ needs
When pitching to investors, it’s important to consider their needs and constraints. Do their deals always involve owning 20% of the company? Do they only write cheques for a specific amount of money? Are they Seed, Series A or growth investors? Does your business strategy match their investing approach? Doing your homework helps you seek out investors that match your business goals, understand your business and craft a suitable pitch.
5. Not researching your financing options
Various financing options have different dilution impacts. For example, convertible debt may be worth considering for companies that believe their shares will increase in value. Most VC’s will put a cap or ceiling on the conversion price and the goal is to beat it over the term of the financing.
Convertible debt allows a business to borrow money from an investor and repay the loan by converting it into a certain number of shares at a future date. Convertible debt allows the company to raise equity at future price without having to prepare a new shareholders’ agreement which can save time and costs.