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:

"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).

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.

Option pool

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:

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.

Reverse vesting

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:

Pro-rata rights

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:

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.

Liquidation preferences

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.

Conclusion

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 ...

We are in the middle of a big technological and economic shift, driven by the web, in how large organizations and industries operate. At Acquia, we have set out to build the best platform for helping organizations run their businesses online, help them invent new ways of doing business, and maximize their digital impact on the world. What Acquia does is not at all easy – or cheap – but we've made good strides towards that vision. We have become the backbone for many of the world's most influential digital experiences and continue to grow fast. In the process, we are charting new territory with a very unique business model rooted Drupal and Open Source.

A fundraise like this helps us scale our global operations, sales and marketing as well as the development of our solutions for building, delivering and optimizing digital experiences. It also gives us flexibility. I'm proud of what we have accomplished so far, and I'm excited about the big opportunity ahead of us.

The reason the answers vary so much is because what is best for the entrepreneur is seemingly at odds with what is best for the business. For the entrepreneur, the answer can be as little as necessary to avoid dilution or giving up control. For the business, more money can increase its chances of success. I feel the right answer is somewhere in the middle – focus on raising enough money, so the company can succeed, but make sure you still feel good about how much control or ownership you have.

But even "somewhere in the middle" is a big spectrum. What makes this so difficult is that it is all relative to your personal risk profile, the quality of the investors you're attracting, the market conditions, the size of the opportunity, and more. There are a lot of parameters to balance.

I created the flowchart below (full-size image) to help you answer the question. This flowchart is only a framework – it can't take into account all decision-making parameters. The larger the opportunity and the better the investors, they more I'd be willing to give up. It's better to have a small part of something big, than to have a big part of something small.

Some extra details about the flowchart:

• In general, it is good to have 18 months of runway. It gives you enough time to figure out how to get your company to the next level, but still keeps the pressure on.
• Add 6 months of buffer to handle unexpected bumps or budgeting oversights.
• If more money is available, I'd take it as long you don't give away too much of your company. As a starting point for how much control to give up, I use the following formula: 30% - (5% x number of the round). So if you are raising your series A (round 1), don't give away more than 25% (30 - (5 x 1)). If you are raising your series B (round 2), don't give away more than 20% (30 - (5 x 2)). If you start with 50% of the shares, using this formula, you'll still have roughly 20% of the company after 5 rounds (depending on other dilutive events such as option pool increases).

My view is that of an entrepreneur having raised over $120 million for one startup. If you're interested in an investor's view that has funded many startups, check out Michael Skok's post. Michael Skok is Acquia's lead investor and one of Acquia's Board of Directors. We both tried to answer the question from our own unique viewpoint.

Acquia is the largest provider of Drupal infrastructure in the world. We run on more than 8,000 AWS instances and serve more than 27 billion hits a month or 333 TB of bandwidth a month. Working with AWS has been an invaluable part of our success story, and today's investment will further solidify our collaboration.

We did not disclose the amount of the investment in today's news announcement.

The round is led by New Enterprise Associates (NEA), one of the world's top investors in our space. They have made various great investments in Open Source (MongoDB, Mulesoft, etc.) as well as SaaS companies (SalesForce, Workday, Box, etc.).

With the new funding, we can continue to go after our vision to help many more organizations with their digital platform and digital business transformation. In addition, Acquia is charting new territory in the world of software with a very unique business model, one that is rooted in Open Source and that helps us build a web that supports openness, innovation and freedom.

We have such a big and exciting opportunity ahead of us. This vision will not come to life on its own and the proprietary competitors are not resting on their laurels. We'll use the funding to double down on all aspects of our company; from increasing our investment in products to deeper investments in sales and marketing.

In addition to lead investor NEA, other investors include Split Rock Partners, and existing investors North Bridge Venture Partners, Sigma Partners, Investor Growth Capital, Tenaya Capital, and Accolade Partners. The new funding will bring Acquia's total fund-raising to $118.6 million.

Of course, none of this success would be possible without the support of our customers, the Acquia team, our partners, the Drupal community and our many friends. Thanks so much for supporting Acquia!

It's a lot of money but we're on a big mission. We believe that Drupal is uniquely positioned to provide a single, unified platform for content, community and commerce applications. We believe an Open Source platform like Drupal is the best way to keep up with the evolving web. We believe we can take on a large variety of proprietary competitors across different industries. We know it is true because we've seen Drupal invade enterprises and overturn their established web technologies. We believe Acquia is breaking new ground with our combination of cloud products and business models.

We've made good strides towards this mission. Drupal continues to grow faster than proprietary competitors. And as Acquia, we have grown to 250 employees and are well on our way to posting around $44 million in annual revenue this year on $60 million in bookings. Specifically, Acquia's revenue has grown at 250% CAGR over the past 3 years, making us the fastest growing software company in the US according to Inc. We added more than 100 employees in the past 12 months. We've seen some incredible growth across the board.

But we also believe we are just getting started. We are in the middle of a big technological and economic shift in how large organizations build and maintain web sites. We believe that Drupal and Acquia are poised to come out as the dominant player.

We'll use the additional funding to continue to go after our mission. We're set out to build a successful, high-margin, highly defensible software company. Expect to see us use the money to accelerate our sales and marketing efforts, to continue our international expansion across Europe and Asia Pacific, to grow each of our product teams, and even to build more products. Part of our funding is also to make Drupal more relevant and easier to use by digital marketers and site builders - and things like Project Spark are a critical element of this. As Acquia builds products, we're committed to contributing to the Drupal project - to drive adoption of Drupal and make it more competitive with proprietary CMS players.

Press coverage:

• Acquia press release: Acquia completes $30 million financing
• Techcrunch: Acquia lands $30 million Series E to scale out its enterprise Drupal development platform (video interview)
• Venture beat: With $30 million in funding, Acquia edges closer to an IPO
• Forbes: Acquia looks to 2014 IPO with new $30 million round
• The Next Web: Open-source Drupal software startup Acquia bags $30 million to fuel expansion in Europe and Asia
• Reuters: Open Source software firm Acquia raises $30 million
• Boston Business Journal: Acquia raises $30 million, foresees IPO as soon as next year
• Xconomy: Pre-IPO Acquia lands another $30 million, sees sales topping $56 million
• Wall Street Journal: Acquia funded for expansion of content-management technology
• De Tijd (Dutch): IT-Belg Buytaert haalt 30 miljoen dollar op
• Datanews (Dutch): Acquia haalt 30 miljoen dollar op

This is an incredibly exciting time to be at Acquia. Since the series C last November, our staff size has almost doubled, from 70 to 130. We're bursting out of our office space and will be moving to a bigger, 35,000 square feet office soon. We needed all those people to service our thousand-plus enterprise customers, and to plan for the future with new initiatives, such as Dev Cloud and the newly revised Acquia Network. We broke revenue records in Q1 and Q2 this year, following an extremely successful 2010.

Fundraising rounds usually occur either when a company is doing very well, or when it's doing very badly. When it's doing well, investors want to get in on the action to score big. When it's doing badly, current investors hope to turn it around to avoid losing everything they'd already put into it. By all measures, Acquia is doing very well, and this round of funding only confirms that. This is what is called a "growth round", with the money directed toward two objectives:

• Increase sales and marketing, particularly outside the U.S.. It's clear that there are tremendous opportunities for enterprise Drupal outside of the U.S., as our partners prove every day. We'll start by focusing on Western Europe, but are already planning expansion into Asia.
• Acquire talent and products that complement Acquia's own. These "acquia-sitions" (as we jokingly call them) will continue to beef up our staff, expand our product offerings, and respond to requests we've gotten over our three and a half years in business.

Acquia's growth is a testament to the growth of Drupal; we'll continue to give back to the Drupal community in everything what we do. Acquia wouldn't have made it this far without our customers, our partners, our employees and our friends. Thank you!

Selling a product has more upside potential than selling consulting and professional services which you can only bill by the hour. However, it is difficult to bootstrap a product based business without a major investment of funds – usually from outside investors. I've seen many try and fail. In almost all cases, it failed because the company was under-capitalized. It takes a lot of resources to create a successful and defensible product. Furthermore, people tend to forget about sales and marketing. It's not enough to build your product – you have to bring it to market as well. That is not trivial either.

I know bootstrapping is hard because I'm bootstrapping Mollom. I know building a product is hard because every day at Acquia, I see how much time and effort goes into our different products.

I don't have a rich uncle, so I would not have been able to co-found Acquia without venture capital financing. We decided that we wanted to focus on being a support and software product company with a strong partner eco-system. Starting Acquia wasn't the easiest route for me, but looking back at the past three years of Acquia, I believe that I made the right decision. Based on how much Acquia has contributed to Drupal and what it has enabled me to do, I like to believe it would have been a loss if I had taken a more conventional route – or had I decided to continue to work on Drupal as a hobby project.

It's refreshing to see that more and more Drupal companies aspire to become successful product companies and that they are seeking venture capital. I always admired the Ruby on Rails community for its seemingly entrepreneurial attitude. I'm glad to see more of it in the Drupal community as well. There is a good deal of fear surrounding venture capitalists but if Drupal is going to grow, we should expect to see more venture-backed companies building Drupal products. Venture capital financing can be good, especially if these companies give back to Drupal and if they build products and services that make our life easier. We all benefit from that.

Based on my own thoughts and my informal survey, my current best answer is the following: the right amount of money to raise is somewhere between the following two choices: (1) enough to build the business that you want to build and (2) as much as you can without being insane or irresponsible. Unless the company does incredibly well, the difference won't be that large.

Raising less money than you actually need can be really destructive. First, it could cause you to miss opportunities because you won't be able to expand fast enough. Second, the company might not survive unexpected setbacks. Last but not least, without sufficient capital you might not be able to attract or retain the right talent you'll need.

Conversely, raising too much money unnecessarily dilutes the ownership of both the founders and the employees. It also makes it difficult to raise more money later on. And it makes it harder to sell the company: the more money you raised, the bigger the price tag becomes as the investors will look to make a multiple on their investment. At a minimum (worst case), you will have to sell the company for at least the total liquidation preference – hopefully a 1x non-participating.

When in doubt, raise more money rather than less. Growing a start-up is hard as it is. You don't want to introduce more risk by not having enough capital. You want to be able to run a few experiments, make a few mistakes or be able to take advantage of unexpected opportunities.

Being able to project how much cash you'll need is an important discipline to master. Cash is the lifeblood of any company. Making financial projections and forecasts is obviously more difficult when the company is pre-revenue or just starting to take in revenue. You'll have to make many assumptions.

Trying to determine how much money you need feels like trying to solve an equation with too many unknowns. It's a balance between the size of the opportunity, increasing the likelihood of success, optimizing for the financial outcome of all employees, the business' situation relative to the market, and so forth.

At Acquia, we made assumptions about the number of customers, average sale price, customer acquisition cost, product mix, etc. We used these assumptions to estimate our costs and revenues. To help ensure that we weren't fooling ourselves, we tried to validate as many of our assumptions by talking to other entrepreneurs and comparable companies. So we talked to key people from other Open Source companies (e.g., MySQL and jBoss) that are in the commercial support business.

The better your assumptions, the better you can estimate how much capital it takes to build your company. In each of our funding rounds, we raised at least enough money to achieve our goals and some extra beyond our plans to handle bad surprises or unexpected opportunities. So far, that has been a good strategy for us.