An in-depth overview of the dilutive effects of multiple rounds of funding, reverse vesting, options pools, pro-rata rights and liquidation preferences.
As founders of startups raise money from investors, their share of the company gets "diluted". This means the percentage of the company they own gets smaller and smaller. Last month a friend asked me the following question: "What do you believe would be a good equity position as a startup founder after a Series A? I don't want to be diluted too much.". This week, another friend who is in the process of raising money asked me if he should accept certain "preferences" from his potential investors in favor of a higher valuation and less dilution.
My answer to both friends was: "Well, euh, it's complex!". Because I get asked about this regularly, I decided to write a blog post about this. In this blog post, I'll discuss the dilutive effect of (1) multiple rounds of funding, (2) reverse vesting, (3) options pools, (4) pro-rata rights and (5) liquidation preferences.
Valuations, multiple rounds of funding, option pools, reverse vesting, pro-rata rights and liquidation preferences can all have a dilutive effects on startup founders. As with everything, the devil is in the details — and hopefully this blog post will help you be a bit smarter about raising money and negotiating term sheets.
Raising Series A
Let's assume that we have a company, and that our company raised four rounds of financing the past five years:
|Series A||Series B||Series C||Series D|
"Pre-money valuation" refers to a company's valuation before it receives outside financing, while "post-money valuation" refers to the company's value after the capital injection. So, the post-money valuation is the sum of the pre-money valuation plus the capital raised. The pre-money valuation of your company, along with the amount of capital raised will determine the founders' dilution.
If our company raises its first round of funding (Series A) with a pre-money valuation of $4 million and the Series A investors were to commit $1.3M, the company would have a post-money valuation of $5.3 million. In the example, the Series A investors would receive 25% of the company ($1.3 million is 25% of $5.3 million).
|Series A investors||25%|
In an earlier blog post, I recommended a specific formula for deciding how much to give up to an investor in each round. For consistency, this post follows that formula. I consider this formula to be an ideal scenario, and recognize that most founders will be in a situation where they have to give up much more, or even be in a situation where they want to give up more. Don't get hung up on the actual numbers used in our example.
You would think that in our example, the founders would be left with 75% of the company after raising their Series A. Unfortunately, this is not usually the case; investors will often insist that an "option pool" is created. An option pool is an amount of the startup's common stock reserved for future employees. Investors expect the employee option pool will equal 10%-20% of the company post-investment; they also expect these shares will be set aside from the founders' equity.
Let's say that the Series A investors' term sheets requires a "15% fully diluted post money option pool" to be setup. This means that the investors want 15% of the company, after the financing is closed, to be in an option pool that will be granted to future employees. The "capitalization table" of our company after the Series A would look like this:
|Series A investors||25%|
|Employee option pool||15%|
The bottom line is that instead of owning 75% of the company, the founders will end up owning 60% of the company, and the investors 25%. For the founders, the $1.3 million financing was not 25% dilutive but 40% dilutive.
As an entrepreneur, I think it is flawed to take the option pool out of the founders' equity; the option pool should be carved out after the financing and dilute both the founders and the investors. After all, future employees who are granted options after the financing add value to the post-money valuation of the company. I'll leave that gripe for another blog post but for the purpose of this blog post, the key take-away is that creating an option pool is usually dilutive for the founders and an important part of the negotiation with investors. The option pool size and the pre-money valuation need to be looked at together and can both be negotiated. Investors should price on the basis of a complete team needed to execute on the opportunity. If the founders have done a good job of hiring that team, the pool size should be smaller. If there are still a lot of hires needed to create a full team to execute, then the pool needs to be larger.
Stock options provide employees the right to purchase a set amount of shares for a set price in the future. To encourage employees to stick around, they don't gain control over their options for a period of time. This period is known as the "vesting period". Once the options are vested, they can be exercised. When you exercise the stock options, you buy shares in the company, usually at a very low price.
Founders are different from employees because they received their shares when they started the company — they don't usually have stock options. To make sure that founders stay with the company, investors will set up a "reverse vesting" strategy. This is similar to "stock option vesting" except that it gives investors the right to repurchase shares already owned by the founders. The "vesting period" in this context measures how many shares the company can repurchase from a departing founder. The longer a founder stays with the company, the less stock the company can repurchase if a founder were to leave.
A founder who remains with the startup through the end of a particular vesting period — typically four years — will be fully vested and retain all founder's shares. The founder who leaves before the vesting period expires will most likely be diluted as the company repurchases some founder's shares.
Raising Series B
As our company grows and the time comes to raise a Series B, the expectation is that the valuation of our company has increased. Let's assume we used that $1.3 million well, and that the value of the company grew from $5.3 million to $13 million.
If we raise $3,250,000 additional capital in a Series B financing on a pre-money valuation of $13 million, then the series B investors will get 20% of the company. In the Series B, the founders, the employees (option pool), and Series A investors are all diluted. Often the new investors will require that the option pool is increased. Let's say they want the option pool to remain at 15% — in this case, the founders, employees and Series A investors would suffer additional dilution on top of the 20%. In our example, the total dilution will be a little over 23%. The new capitalization table looks as follows:
|Series A||Series B|
|Series A investors||25%||19%|
|Series B investors||20%|
|Employee option pool||15%||15%|
It's not always as simple though. Investors will usually insist on "pro-rata rights". Pro-rata rights give investors the right to invest in a startup's future rounds and maintain their ownership percentage as the company grows and raises more capital. It is an important tool for early stage investors, as most of their investments fail. Pro-rata rights allow investors to "follow" the investments that are doing well. Their ability to double-down on winners is important to compensate for their losses. I believe it is fair to give early investors pro-rata rights; they are a reward for backing you early. But as I've learned, this is also where things get complicated.
At times, new investors don't want older investors to participate so that they can take more of the round. Usually, the new investors will insist that they put enough money to work so they can own a substantial-enough share of the company to make the investment worth their time and effort. In this case, the new investors will try to force the old investors to give up their pro-rata rights. Other times, the new investors want early investors to demonstrate their confidence in the company by participating in the round, and to show that they are not overpaying. To facilitate the "pro-rata dance" between investors, and to satisfy both the old and new investors, founders are often required to take more dilution and to give up more of their company. For simplicity, I ignored pro-rata rights in our running example, but founders need to be aware of how pro-rata rights can impact dilution in later funding rounds.
Raising Series C and Series D
Our company continues to grow and goes on to raise Series C and Series D:
|Series A||Series B||Series C||Series D|
|Series A investors||25%||19%||15%||14%|
|Series B investors||20%||16%||15%|
|Series C investors||15%||13%|
|Series D investors||10%|
|Employee option pool||15%||15%||15%||15%|
In our example, the founders would end up with 34% of the company after four rounds of financing (assuming no additional option grants for the founders). As mentioned above, I consider that an exceptional outcome for the founders. Most founders will own substantially less at this point. For example, Aaron Levie, founder of Box, owned about 4% of Box when the company made its public offering in 2015. Zendesk founder and CEO Mikkel Svane owned about 8% at its IPO in 2014, and ExactTarget's co-founder owned 3.8% at the time the company filed its S-1.
But there is more — I warned you it's complex! When investors put money in your company, they will require the company issue them "preferred stock". Investors' preferred stock has various "preferences" over "common stock", owned by founders and employees. One of the most common preferences are "liquidation preferences". A liquidation preference helps investors make sure that they'll be paid before common shareholders when a company is sold, declares bankruptcy, or goes public. This is especially important when the company is being liquidated for less than the amount invested in it.
If our company was to sell for $75 million, you would think that per the table above, the Series D investor would make $7.5 million (10% of $75 million) and the founders would make $25.5 million (34% of $75 million). However, if our Series D investor negotiated a "liquidation preference" equal to their $10 million investment and the company is sold for $75 million, they will be guaranteed their $10 million back. The remaining $65 million would go to the other shareholders. This is called a "1x liquidation, non-participating preference". In the event the company sells for less than the valuation at the time of the investment, the Series D investors will make more than their percentage ownership, and the founders will make less than their percentage ownership. In other words, when your investors have liquidation preferences, your percentage ownership isn't always what it looks like on paper (or in a capitalization table, to be exact).
Sometimes, investors want "participation rights". In the case of "participation rights", the investors would be entitled to the return of their entire investment prior to the distribution of any proceeds to the common stockholders. However, the preferred stockholders would then also be treated like a common stockholder and would share in the remaining proceeds. If our company sells for $75 million, the Series D investors would get their $10 million out first, and then get their 10% share of the remaining $65 million for a total return of $16.5 million ($10 million + 10% of $65 million).
There is also a concept called a "multiple". Where founders and employees can get really hurt is when preferred stock owners have a 2x or 3x multiple. If our Series D investors have "3x liquidation rights, participating", they would be guaranteed $30 million back (3 times $10 million) and take 10% of the remaining $45 million. The founders would make $15.4 million. Instead of their 34% share, the founders only get 20%. So, before you agree to any liquidation multiple or participating rights, you should run a few models to understand how much you and the other founders will receive based on various liquidation scenarios.
Because of the preferences, the price or market value of common stock is typically much smaller than that of preferred shares — especially in the early days. Because common stock is worth less than preferred stock, your percentage ownership is often meaningless. This is often evidenced either by a 409(a) valuation in the USA, or the market price of common stock when sold to a third-party. Preferences generally expire at an IPO, at which time preferred stock converts into common stock. At that point, common and preferred shares have the same value.
In summary, valuations, multiple rounds of funding, option pools, reverse vesting, pro-rata rights and liquidation preferences can all have a dilutive effects on startup founders. As a founder, it can be difficult to predict or plan how much dilution you will suffer along the way. As with everything, the devil is in the details — and hopefully this blog post helped you be a bit smarter about raising money and negotiating term sheets. In general, I don't think founders should worry about dilution too much but that is a topic for a future blog post ...