Fundraising, Growth, and Dilution

3 minutes, 4 links
Holloway Guide ToEquity Compensation
Common questions covered here
Why are fundraising and venture capital important to startups?
How do fundraising, growth, and dilution relate to the stages of a startup?
What does increased dilution indicate about the value of my shares?

Fundraising, Growth, and Dilution

Many large and successful companies began as startups. In general, startups rely on investors to help fund rapid growth.

Definition Fundraising is the process of seeking capital to build or scale a business. Selling shares in a business to investors is one form of fundraising, as are loans and initial coin offerings. Financing refers both to fundraising from outside sources and to bringing in revenue from selling a product or service.

Definition Venture capital is a form of financing for early-stage companies that individual investors or investment firms provide in exchange for partial ownership, or equity, in a company. These investors are called venture capitalists (or VCs). Venture capitalists invest in companies they perceive to be capable of growing quickly and commanding significant market share. “Venture” refers to the risky nature of investing in early-stage businesses—typically startups—with unproven business models.

A startup goes through several stages of growth as it raises capital based on the hope and expectation that the company will grow and make more money in the future.

Definition Companies add (or “issue”) shares during fundraising, which can be exchanged for cash from investors. As the number of outstanding shares goes up, the percentage ownership of each shareholder goes down. This is called dilution.

confusion Dilution doesn’t necessarily mean that you’re losing anything as a shareholder. As a company issues stock and raises money, the smaller percentage of the company you do have could be worth more. The size of your slice gets relatively smaller, but, if the company is growing, the size of the cake gets bigger. For example, a typical startup might have three rounds of funding, with each round of funding issuing 20% more shares. At the end of the three rounds, there are more outstanding shares—roughly 73% more in this case, since 120%×120%×120% is 173%—and each shareholder owns proportionally less of the company.

Definition The valuation of the company is the present value investors believe the company has. If the company is doing well, growing revenue or showing indications of future revenue (like a growing number of users or traction in a promising market), the company’s valuation will usually be on the rise. That is, the price for an investor to buy one share of the company would be increasing.

danger Of course, things do not always go well, and the valuation of a company does not always go up. It can happen that a company fails entirely and all ownership stakes become worthless, or that the valuation is lower than expected and certain kinds of shares become worthless while other kinds have some value. When investors and leadership in a company expect the company to do better than it actually does, it can have a lot of disappointing consequences for shareholders.

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