Equity Dilution for Early Stage Startups

May 5, 2023

If you’re an early-stage startup, it’s easy to get caught up in the world of fundraising. The more you chase growth, the more you lose control of your equity.

Equity dilution is the decrease in the equity stakes owned by a company as a result of the issuing of new shares. Many startup owners think their goal should be to have a small equity stake of a larger company as opposed to a large equity stake in a smaller company. Though this may work in practice, a failure to make the right calculations can actually put you in a position where you earn less than what you initially did. So how can you know what the right amount of equity dilution you should do for your startup?

Firstly, it is important to understand that equity dilution is both good and bad for a company. Equity financing allows startups, which may not be able to directly pay investors back, to raise finance to fund expansions. It also means businesses do not have to worry about paying their investors back and sometimes even allows them to acquire additional knowledge and resources (if they raise capital through sources such as venture capitalists and angel investors). However, it is also bad as it leads to loss of control and future profits. For example, if your current valuation is $15 million and you own 70% of the company, you would have $10.5 million in your pocket. You decided to expand your company and gave venture capitalists 40% of your equity in exchange for $8 million. This allows you to acquire resources to grow your company to have a $30 million valuation. However, your equity is now worth $9 million. Although your company has grown, your finances haven’t.

Although there isn’t a perfect percentage of equity you should give up, ideally, for the seed stage rounds, you should plan to give up around 10% to 20% of your company’s equity. Companies are expected to give up 15% to 25% in Series A fundings. By the time you complete Series C or D fundings, you should expect to have given up 20% to 40% of your company. However, it may be hard to keep on track of your equity dilution, so how can you make sure you’re on the right track?

Only take what you need- Before going to investors, ensure you have an exact value of the amount of funding you’re going to ask. Though it may be tempting, even if investors ask for more equity in exchange for larger investments, try to refrain unless you truly need the money.  Not only will this help you retain control over your startup but also prevent over-scaling your startup. Having access to too much funding can lead to higher expectations from the business, which if you are unable to attain- can lead to a poor brand image. It can also reduce the number of profits that are able to be reinvested into the business for growth. In other words, greed for funding can lead to your demise.

Don’t start with equity financing- Some startups that try to start the funding process with venture capitalists or angel investors can often either fail to do so or end up losing too much equity in the process. If the startup is still in the ideation phase, it is likely that investors will be expecting a higher equity stake in return for the same investment as compared to if the business is already in the market. Instead, you should start with bootstrapping, which is a way of raising capital through personal funds, friends and family. Alternatively, try using debt for revenue financing. This will allow you to retain the funding you need while still keeping your equity dilution at a minimum.

Gradually give up equity stakes- What may help businesses is to give up small equity stakes every round of funding rather than large equity stakes at once. If you are raising funds through a venture capitalist, instead of giving up 10% to 15% in round A, try to give up around 2% to 6%. This will allow you to raise as much capital you need for the next couple of months/years, further grow your business and charge more for each share of your company in further rounds. Eventually, you may reach the stage where you are a large enough company without the need to use equity financing- and you haven’t even diluted your equity to the extent you would have if you gave into the 20% stake.

Plan your ESOPs pool to avoid unnecessary dilution- If you’re an early-stage startup, giving equity shares to your employees is a good way to get them excited about your company and reduce employee turnover. You might want to go above and beyond for your employees, but to avoid unnecessary dilution, it’s best to stick to giving 0.1% to 0.3% stakes to your initial employees.

Work with investors who prioritize your business goals- The most important thing is to make sure you trust your investors. Not knowing your investor’s intentions, such as working with shark investors, could lead to being taken advantage of and being forced to give up your equity. Since they also gain control of your business with each equity stake, working with investors who don’t understand your goals can lead to your business going down the wrong path.

To sum up, to ensure the success of your business, it’s important to keep track of your startup’s equity dilution and ensure you are primarily in control of your business.

Wrapping Up

Here at GrowthPal, we connect the buy-side and sell-side through our deal origination platform leveraging a quality startup database, allowing your early-stage startup to raise high amounts of funding in exchange for low amounts of equity. Visit www.growthpal.com for more information or contact us directly at support@growthpal.com to learn about what we can do for you company.

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