As a founder, do you truly understand how dilution and valuations work?
Before you launch your company, you’ll be putting together your financial plan. This should include knowing how much valuation and how much dilution you’re willing to take as a founder. These two topics can seem very scary at first, but they’re really not that complicated once you understand the basics. Let’s look at what these terms mean and why they matter so much for founders.
What is Dilution?
Dilution is a fancy way of saying “reduction of ownership.” In the context of business, it refers to the amount by which the percentage of ownership each person has in the business is reduced as a result of adding new equity. When a company issues new shares or securities, the owners of the company (i.e., the shareholders) will have less ownership of the company. So, the owners are diluted. The amount by which owners are diluted is called dilution. A good example would be a company that wants to raise $1 million from 10 new investors to finance its new product. If each investor puts in $100,000, then the total amount of money invested in the company is $1 million. If the company issues 10 million shares (each share represents 1/10 of the company), each investor now owns 1/100 of the company. So, you can see how the total amount of money invested stays the same while the ownership percentage changes. This is dilution.
What is Valuation?
Valuation is the amount of money an investor will pay for a percentage of your company. Founders often confuse two terms: valuation and price per share. The price per share is what an investor pays to own a percentage of your company. And that price depends on the valuation of your company. The valuation of a company is an educated guess of what your company is worth when all is said and done. It could be the amount of money you plan to raise from investors, the amount of money you’ll be making in revenue, or a combination of both. All companies have a valuation, even if it’s just a really rough estimate. You can’t really have a business plan without a valuation.
Why Does it Matter?
As a founder, you’re going to be negotiating with a lot of people, especially investors, who will want to own a piece of your company. The amount of ownership they will have in the company will be determined by the amount of money they want to invest in your company. And the amount they’re willing to pay for a percentage of your company will be determined by your valuation. When it comes to dilution, one of the most important factors is the price per share. If the price per share is too low, the investor will own too much of your company, and you’ll lose a significant amount of control. You may feel like it’s a great opportunity because the investor is willing to pay you a lot of money, but you need to consider what percentage of your company they will own. If the price per share is too high, though, you won’t be able to attract as many investors, and you’ll have less money to grow your business.
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It’s all about the percentage of ownership
If you’re a founder, the one thing you need to know about dilution is that it’s all about percentage ownership. The more shares a new investor buys, the more they own of your company, and the less you own. Before you start negotiating with investors, you need to know how much you’re willing to give up in terms of ownership and how much you’re willing to give up in terms of control. It’s also important to understand that everything is negotiable. Investors will usually have a set valuation in mind for your company, but you’re not going to get the same terms from every investor.
When does dilution matter?
Dilution matters most when you’re raising money. You’ll have to decide how much you’re willing to give up in terms of ownership for each round of financing. So, how much ownership do you want to give up? When you’re raising your first few rounds of financing, you’ll probably want to limit your dilution to less than 15%. This is because you need to keep enough equity in the company to be incentivized to do a great job. You’re going to be working your butt off to make your company successful. So, you need a certain amount of equity to be able to stay motivated. When you give up too much equity, you lose your incentive to put in the hard work.
Rule of thumb: Be wary of any round with more than 15% dilution.
If you’re negotiating with a seed or series seed investor, you should be wary of any round that is over 15% dilution. If an investor is asking for more than 15% dilution, you should walk away. If an investor is asking for less than 15% dilution, you should be wary if the amount they’re offering for your company’s valuation is very low. When you’re negotiating with investors, keep in mind that they’re looking for a great return on their investment. You’re looking for investors who will help your company grow. You both want the same thing: a successful company. The only difference is how you get there. So, it’s up to you to negotiate terms that will benefit both you and your investors.
Founders need to be aware of dilution and how it affects your company. Dilution happens every time you decide to raise money from investors. The more money you raise, the more diluted you become. It’s important to understand the impact of dilution on your company so you can make informed decisions about how much ownership you’re willing to give up. If you’re not careful, you could end up giving up too much ownership in exchange for funding. That may sound like a good idea since you’ll have a lot of funding, but if you give up too much ownership, you won’t have any control over the company you founded.
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