Dilution From Selling Priced Shares to Investors

18 minutes, 1 link


Updated August 29, 2023
Angel Investing

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What follows is a simple example of how ownership gets diluted with the selling of shares. In the next section, we’ll bring it all together and talk about how those shares get priced.

In a priced round, the company issues shares out of its authorized stock, either common stock, or more typically preferred stock. A specific number of those shares are sold to investors at a specific price. This new stock gets added to the cap table, which increases the number of issued and outstanding shares. All the existing shareholders (founders, prior investors, employees with stock options, advisors) have the same number of shares or options they had before the transaction, so they are all diluted in their ownership by the increase in the denominator (total number of shares).

founder Every time founders raise more money or issue stock options for new employees, they dilute their ownership. Prior investors are also diluted by these activities. The degree of dilution is determined largely by the ratio between the amount of money being raised and the pre-money valuation. If the founders raise too much money before they can justify a high valuation, they give up too much of the company too early.

importantThe 50% ownership mark is an important threshold for founders. Those who control more than 50% of the company’s stock have a lot of control over the company. Any significant corporate activity around issuing more stock or how the board is structured, for example, can ultimately be controlled by owning a majority of the stock—unless the founders have agreed to specific control provisions for investors. Once the founders have sold off more than 50% of their stock to investors, they have essentially lost control of the company they founded. Because of this, you may see resistance among founders to going below the 50% threshold too early.

founderA good rule of thumb for entrepreneurs is not to sell off more than 20% of the company in any single financing round. Pete has seen naive entrepreneurs pitch a financing of $400K on a $600K pre-money valuation. The result would be selling off 40% of the company in the first investment round. Future rounds will continue to dilute the founders and early investors. You don’t want founders to get to a low percentage ownership early in the process or they may not see a lot of upside and lose motivation.

important To manage ongoing dilution, the pre-money valuation for each successive round has to grow dramatically. This is why it is so important that startups hit their operational milestones (improving the product, getting customers, et cetera) and do as much as possible with the money they raise at each step.

Let’s take another step with Pext, Inc. and see how the amount of money raised and the pre-money valuation impact how much the founders own at the end of two rounds under two different sets of assumptions.

Scenario A: Raising $250K

examplePext, Inc. raises its first external round as a priced round, closing a $250K raise with a $1M pre-money valuation. (If you have been reading carefully, you would rightly object to a priced round for a raise of only $250K, and suggest a SAFE or convertible note instead, but bear with us so we can illustrate the dilution!) If the pre-money is $1M, the post-money valuation in this case will be $1.25M (pre-money valuation plus amount raised), and the percentage of the company sold will be 20% ($250K/$1.25M). Let’s say that our savvy investors insist that their ownership should be calculated on a fully diluted basis.

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FIGURE 3S: Summary cap table prior to any investments

Consolidating the cap table above (Figure 3) to aggregate founders and employees prior to investment:

Shares or OptionsIssued and OutstandingFully Diluted
Employee 1345,0003.33%3.00%
Issued and Outstanding10,345,000100.00%
Option Pool Available1,155,00010.04%
Total Fully Diluted11,500,000100.00%

Figure A1: Impact of Raising $250K on $1M Pre-Money Valuation, Fully Diluted Basis

Shares or OptionsIssued and OutstandingFully Diluted
Round 1 Investors2,875,00021.75%20.00%
Issued and Outstanding13,220,000100.00%
Option Pool1,155,0008.03%
Total Fully Diluted14,375,000100.00%

Let’s assume that $250K lasts a year (founders are taking minimal salary), and Pext has made great progress. They now have a fully functioning app in the Apple app store with 10K downloads and great early customer engagement numbers. They want to hire a full time app developer and a full time marketing person. Based on the customer engagement and their execution to date overall, they raise another $750K round of funding, and convince investors that they are worth $3M pre-money. Again, they will be selling another 20% of the company: (750K/(3M + 750K)) = 20%. This would be a typical scenario.

The post-money valuation after the first round was $1M + $250K = $1.25M. So this is a great progress in the valuation from one round to the next ($1.25M post to $3M pre-money), and is called an “up-round.”

Figure A2: Impact of Then Raising $750K on $3M Pre-Money Valuation, Fully Diluted Basis

Shares or OptionsIssued and OutstandingFully Diluted
Round 1 Investors2,875,00017.10%16.00%
Round 2 Investors3,593,75021.37%20.00%
Issued and Outstanding16,813,750100.00%
Option Pool1,155,0006.43%
Total Fully Diluted17,968,750100.00%

At this point, everything is going well and the founders own almost 56% of the stock on a fully diluted basis. The Round 1 investors have been diluted from their initial 20% down to 16% by the Round 2 investors.

Scenario B: Raising $500K

For comparison now, let’s look at scenario B, where the founders raise $500K instead of $250K on the same $1M pre-money valuation. Now they are giving up a third of the company in the first external round.

Figure B1: Impact of Raising $500K on a $1M Pre-Money Valuation, Fully Diluted Basis

Shares or OptionsIssued and OutstandingFully Diluted
Round 1 Investors5,749,13835.72%33.33%
Issued and Outstanding16,094,138100.00%
Option Pool1,155,0006.70%
Total Fully Diluted17,249,138100.00%

In scenario A, the founders owned roughly 70% after the first raise, in scenario B, they only own 58%. They have given up 12% of the company for the extra $250K. They would have to make a lot more progress on that extra $250K in order to bring up the pre-money valuation for the next round well beyond what they could have done with only $250K.

founder Raising a large round relative to the pre-money valuation is brutal on the existing stockholders—both the founders and any existing equity investors. (Careful readers will point out that raising money is a big distraction for a company and ask if it isn’t better to raise as much as possible each time? This is a tension for the founders.)

Following scenario B for a final illustration, let’s assume that the company didn’t make as much progress with the $500K (they spent a lot of time finding a cool office and buying expensive furniture, bought a pricey domain name, hired a well-known design firm to do a cool logo, and they over-hired and over-spent in marketing before the product was ready.*)

When they went to raise another round, they could only convince investors that the pre-money was $1.5M. The post-money valuation from the first round was $1.5M ($1M pre + $500K = $1.5M). This is a “flat round,” where the pre-money valuation has not grown. An even worse scenario is a “down round” where the pre-money valuation goes down from the previous post-money valuation.*

Figure B2: Impact of Raising $750K on a $1.5M Pre-Money Valuation, Fully Diluted Basis

Shares or OptionsIssued and OutstandingFully Diluted
Round 1 Investors5,749,13823.26%22.22%
Round 2 Investors8,623,27534.89%33.33%
Issued and Outstanding24,717,413100.00%
Option Pool1,155,0004.46%
Total Fully Diluted25,872,413100.00%

In scenario B, the founders give up another one third of the company on a fully diluted basis and now own less than 39% of the company. They have less than 50% of the voting shares and have lost a large degree of control of the company. The Round 1 investors have also seen a lot of dilution, from 33.33% to 22.22% ownership of the company.

founderThe key takeaways are that raising too much money relative to the pre-money valuation causes excessive dilution, and not increasing the pre-money valuation enough as the company needs to raise bigger rounds also causes excessive dilution.

important Once you have invested, you suffer the same relative dilution as the founders in successive rounds, so you are aligned in your motivation to quickly increase the value of the company before the company has to raise money again.

These two scenarios were crafted to illustrate the impacts of the dilution resulting from the ratio of the amount raised to the pre-money valuation. We could have written a scenario about a company that raised too little ($250K), burned through it in six months and spent the next six months investing all their time raising money again instead of growing the company. As we noted above, determining the right amount of money to raise should be a carefully considered decision. To reiterate the benefits of convertible notes early on in the fundraising process, the company can raise money more cheaply with less negotiations on terms, and without even setting a pre-money valuation.

Setting the Price Per Share

In the dilution examples above, we determined ownership percentage and the number of shares to be sold to the investors without ever calculating the price per share. We did that by first calculating the percentage being bought by the investors using the pre-money valuation and the investment amount:

To calculate the number of shares, we had to decide which total share number we were going to use (issued and outstanding or fully diluted); and because we wanted as many shares as possible, we chose fully diluted. The formula for getting to the number of shares is:

If you are calculating the number of shares based on issued and outstanding shares only, you would substitute the issued and outstanding shares total for the fully diluted share total in the formula above.

Expressing the post investment ownership percentage in the term sheet is a valid way to ensure that there are no surprises. For example, the term sheet might say:

⚖️legaleseImmediately following the new investment, the purchasers of the Preferred Stock will own X% of the Company, calculated on a fully-diluted basis, including all issued and outstanding shares of stock on an as-converted to common stock basis, all convertible securities outstanding, and an available option pool of [10]%.

If you are going to make an offer to invest in a company through a term sheet, and you don’t know how many securities it has outstanding, and you want to assure yourself of your desired percentage after your money comes in, you will probably express the price per share on a post-money basis.

The basic share price calculation is:

As we explain in Calculating Ownership and Dilution, there are two running share totals and it is possible to use either one in the calculation. The price per share in a fixed price round may be calculated by dividing the pre-money valuation by either the number of shares outstanding—the issued and outstanding shares—or the issued and outstanding shares on a fully diluted basis.

Price Per Share in Scenario A

exampleLet’s look at the difference in the two approaches using our cap table from our scenario A example just above, where the Round 1 investors are buying 20% of the company for $250K at a $1M pre-money.

Figure 3S: Cap Table Prior to Investment

Shares or OptionsIssued and OutstandingFully Diluted
Issued and Outstanding10,345,000100.00%
Option Pool1,155,00010.04%
Total Fully Diluted11,500,000100.00%

Using the fully diluted basis, the price per share is $1M/11,500,000 or $.087 per share. When this company IPOs at $17 per share, you’ll have a 20X return! Checking the math, 2,875,000 shares purchased by the investors (see the post investment cap table in Figure A1) at $.087 each is $250K.

If the investment was instead defined as 20% ownership post investment based on the issued and outstanding shares, the price would be calculated as $1M/10,345,000 = $.097 each. The shares are more expensive, and so the investors only receive 2,586,385 shares for their $250K. That’s 288,615 fewer shares, or roughly 10% less.

importantAs an investor, you clearly want to use as large a pre-investment share total as possible in calculating the price per share (large denominator), so you want the price per share based on the fully diluted calculation. And pay attention to the definition of fully diluted, as it can vary.

The Impact Of The Option Pool On Dilution and Price Per Share

As we saw in the pricing discussion above, the difference between a calculation based on issued and outstanding shares versus fully diluted shares can be significant. The option pool is typically the biggest component of the difference between issued and outstanding and fully diluted shares, and so the size of that option pool tends to get a lot of scrutiny at the time of any investment.

As a company hires employees, it issues grants of options on the stock that is reserved for the stock option pool, thereby slowly depleting that pool. It is common that a company has to top up its stock option pool several times as it grows from no employees to dozens, to hundreds, to potentially thousands. It increases the pool by allocating shares from the company’s authorized stock. When the company adds more shares to the option pool, it dilutes all the existing stockholders (when using the fully diluted ownership calculation). It is a round of dilution without directly bringing in any money (the way a stock sale to investors does). So companies aren’t anxious to top up the pool by themselves.

Savvy investors know that the company should have a healthy stock option pool so it can motivate the new employees it wants to hire with the money it is raising. So as part of almost any priced investment round there is a discussion about how big the pool should be and who is going to take the dilution hit. New investors want to allocate additional shares to the pool in a way that dilutes the existing equity holders before the new investors come in. The company would prefer if the option pool were topped up after the new money came in, as the dilution to the founders and prior investors would be less because the new investors would be sharing in that dilution.

exampleBelow is an example of how Figure A2 would change if the Round 2 investors had insisted that they are buying 20% for their $750K, and they still agree to the $3M pre-money, but now they also insist that the stock option pool be topped up to 15%. If you look back to Figure A2, you will see that the stock option pool is down to 6.43% post investment if it is not addressed. Because the investors have established their 20% post investment ownership (on a fully diluted basis) as part of their investment terms, the full burden of the dilution in this case is borne by the founders and existing investors (and existing employees). The founders go from 55.65% ownership post investment to 49.17%. A big difference. The investors for their part get more shares, 473,942 more, because they require 20% of a larger total of fully diluted shares now.

Figure A3: $750K Investment for 20% Ownership Post Investment, Including Topping up the Option Pool to 15% Post Investment

Shares or OptionsIssued and OutstandingFully Diluted
Round 1 Investors2,875,00016.63%14.14%
Round 2 Investors4,067,69223.53%20.00%
Issued and Outstanding17,270,000100.00%
Option Pool3,050,00015.00%
Total Fully Diluted20,337,692100.00%

Because the investors are now buying more shares for their $750K, the price per share goes down. Another way to think about this is that the investors insisted that the option pool be topped up before they invested. Topping it up required more shares. The option pool prior to the investment had to be increased to 18.75%, so that after the dilution of that option pool by the 20% ownership stake from Round 2, it would be 15%. The price per share in this example is

This is what the investors are paying divided by the number of shares they are receiving; or, using our standard formula of the pre-money valuation divided by the number of fully diluted shares immediately before they invest (after the top up):

The good news is, despite all the dilution suffered by the founders and the Round 1 investors by the savvy Round 2 investors, the price per share has more than doubled from $.087 at Round 1 to $.184 at Round 2. This is a function of the company hitting its milestones and driving up the pre-money valuation.

As an investor, you would like the company to top up the option pool before you invest. We hope that with this understanding of the impact on founders and the prior investors (which may include you or your fellow angels), you will appreciate why the existing stockholders want the new investors to share the burden of increasing the option pool.

Dilution and Conversion8 minutes

So far, we’ve walked through the story of a company that goes straight to raising a priced round, and explored a couple of scenarios to demonstrate some key concepts and mechanics. In this section, we’re going to pick up the story of the same company back after they added their first employee. Instead of going straight to a priced round, the company first raises a convertible note, then a preferred stock round. How will this series of events affect the cap table and investor ownership?

Let’s find out!

Convertible Note to Priced Round

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