How much dilution is "normal"?

Dilution is one of the most misunderstood concepts in startup land. But many employees are afraid to ask for a simple explanation.

Here’s how it works:

Dilution occurs whenever new (more) shares are issued (created). Let's go through some common scenarios:

1/ When the Firm Completes a Fund Raise: This is the most well known scenario. When a company does a fundraise they can raise primary dollars, secondary dollars, or a combo of both.

Secondary dollars are just existing shareholders selling their shares. For example, a longtime founder might sell a portion of their stake and take some dough off the table. None of this money goes to the company to fund operations. And since no new shares are created, they just swap hands; there’s no dilution.

However, when a firm raises primary dollars it creates new shares out of thin air. Doing so increases the denominator that existing shareholders measure their holdings against.

The more primary dollars raised, the more dilution.

2/ When the Employee Stock Option Pool (ESOP) is Increased: Investors will typically ask for an ESOP (Employee Stock Ownership Plan) pool as part of the fundraising terms. That's because setting aside more stock options for future employees buys you access to better talent.

Technically the cap table isn’t “fully diluted” until employees exercise (buy) their new (granted) shares. This involves a vesting period over time - usually a one year cliff followed by monthly vesting for the next three years.

If the employee either doesn’t buy their shares or doesn’t stick around long enough to vest, it doesn’t cause dilution, and the shares return back to the ESOP.

3/ When Convertible Warrants are Exercised: These are usually issued to angel investors as a convertible note, or founder friendly banks as part of the terms o-for a loan. Warrants are useful to early stage companies who’ve yet to do a “priced” round. When debt is converted to equity, this makes the number of outstanding shares go up, which dilutes the existing holders.

Takeaway: The early money you take is often the most expensive. Series A often causes the highest dilution, followed by Seed.

Why Series A? In a Seed round individual angels are often OK with writing smaller checks, especially since it’s still really risky. When it comes to Series A, investors are cutting the largest single check to the firm so far, but the valuation hasn’t ballooned yet to offset the money being put in. Investors are also working backwards, anticipating further dilution in rounds later on, to the percentage they need to hold starting at Series A for their return at exit. This usually ends up being 20% to 25% of the firm at the time.

Dilution isn’t exclusively caused by the new shareholders - it also comes about as existing shareholders exercise their pro rata rights (to the extent they have them) and from ESOP top ups.

Pro Rata rights means you get to buy enough shares to maintain your current ownership percentage.

The chart above shows the net increases (and decreases) in each party’s aggregate holdings on the cap table.

The chart below shows the same data, but aggregated over time as a stacked bar chart where there are only 100 percentage points to go around. Founder’s continually cede points to investors and employees. If a founder makes it to IPO with anything close to 10% they are in remarkable shape. This used to be much easier to do when IPOs occurred after a Series B or C. But with the proliferation of the alphabet rounds, dilution strikes more often as the company stays private longer.

The only bright side to staying private longer and getting diluted is that the valuations at IPO are a lot larger than they used to be. So although founder’s show up to the party with a smaller stake, it’s getting applied to a larger cake.

You can see how in the round before IPO, 60% to 70% of equity resides in the hands of investors. And 20% to 25% is in the hands of non-founder employees.

Let’s say you join a startup right after their Seed round as a Finance Manager (but let’s be real - you probably wear 10 hats). So you’re a mid-level hire really early on. You receive an equity grant equivalent to 0.25% ownership.

What does this look like if we use the examples above and the company makes it through IPO?

Your equity would be cut in half, due to dilution at each round. BUT… you’d 159x the dollar value of your grant from $25K to nearly $4M. I’d make that trade every day of the week. Dilute me, dog, just don’t forget to wire the money.

Dilution is a tax to play the game, one you should be willing to play if your company’s valuation is going up by, say, 50% each round (but probably not in this enviornment).

You have to be aware that the firm is constantly making a tradeoff when they raise capital - jet fuel for ownership. And this tradeoff goes wrong when the firm raises a ton of money, which causes a bunch of dilution, yet is unable to produce an offsetting amount of value.

And that brings me to the next point - despite the sexy WSJ headlines, big, flashy, rounds are not always great. More money may “dilute” focus. It’s much easier to spend on B and C projects (and players) when the bank balance is high.

Yes, you need to gas up the plane to go on the trip, but raising smaller rounds creates constraints and drives focus. No matter how you slice it, there are only 100 percentage points on the cap table to go around. So if you trade points for cash, make sure you can create some outsized returns, since TechCrunch headlines don’t pay the bills.

Y Combinator - Dilution

SVB - Founder Dilution

Lattitud - Pro Rata Rights

Index Ventures - Evolution of Ownership

Quick tip: If you read a lot of newsletters like me, try out the Mecco Newsletter app. It’s like a Kindle for your newsletters on all platforms (Substack, Beehive, Revue, etc.)