How to Avoid Equity Dilution

When scaling a venture, there’s a tried and true three-step method for avoiding equity dilution and exiting with the exact same amount of ownership you started out with:

  1. Bootstrap everything.
  2. Don’t take on any equity investors. Restrict your funding sources to profit, debt, grants, and any personal cash.
  3. Don’t create an options pool for your employees.

Based on these onerous terms, you’ll have realized that we’ve click-baited you. There is no easy way for a high-growth venture to avoid equity dilution. Realistically, you’ll have to give up a piece of the pie to obtain the talent, capital, and network needed to scale fast enough to stay ahead.

Your concern shouldn’t be about equity dilution, but rather value dilution. 50% of $2M might be a cool $1M. But 10% of $50M is an even cooler $5M. Put in American terms, would you rather have half a mini-pan pizza or a tenth of a 30″ Chicago deep-dish pizza?

The Guiding Equation

When it comes to getting out ahead with equity, a general formula should be followed:

PoE/PrV ≥ 1/(1 – n)

Here, PoV = “Post-Event Valuation”, PrV = “Pre-Event Valuation”, and n is the percentage of your company you gave up during the dilution event. What are dilution events you ask? We’ve outlined the most common ones below.

  • Issuances of New Common/Preferred Stock
  • Issuance of Convertable Notes/SAFEs
  • Issuances of Stock Options
  • Issuances of Warrants
  • Conversions of Shares
  • Liquidation Preference Changes
  • Participation Rights Changes
  • Cumulative Dividends

An Employee Example

To make sense of this guiding equation. Let’s look at a company valued at $1M that’s onboarding an early employee and granting them 2% equity. Our equation now looks like this:

PoE/$1M ≥ 1/(1 – 0.02)

next we simplify things:

PoE/$1M ≥ 2.04%

our newly onboarded employee should improve the company’s value by at least 2.04%. Also put as follows:

PoE ≥ $1,020,400

If our newly onboarded employee’s skills and contributions result in less than a $20.4K increase in company value over time, then they’ll end up diluting the value of your remaining 98% ownership. Say the employee only improves outcomes by 1%. Your post-event company valuation is now $1,010,000. Your 98% of that will then be worth $989,800 – substantively less than your original million.

Even with this equation, it can be hard to judge how much equity you should give out to incentivize early hires and still come out ahead in the dilution game. Luckily, there are some good averages calculated by Leo Polovets over at Susa VC.

  • Hire #1: 2% – 3% of equity
  • Hires #2 through #5: 1% – 2%
  • Hires #6 and #7: 0.5% – 1%
  • Hires #8 through #14: 0.4% – 0.8%
  • Hires #15 through #19: 0.3% – 0.7%
  • Hires #21 through #27: 0.25% – 0.6%
  • Hires #28 through #34: 0.25% – 0.5%

These percentages are average maximums and not average values in general. Meaning no more than 2-3% was given out to first hires on average.

This example of employee stock options can be applied to any equity value dilution that is speculative in nature. When an early-stage startup gives 7% equity to an accelerator program, they are banking on that accelerator program raising their value by more than 1/(1-0.07) IE at least 7.5%.

Boosting Before Raising

Let’s take our original guiding equation and move things around a bit to isolate the n.

PoE/PrV ≥ 1/(1 – n)

is now

1-(1/(PoE/PrV)) ≥ n

Unlike our previous dilution events that were speculative on the value they would bring, a funding event is a fixed point in time and a fixed amount of value change. The greater-than symbol in the guiding equation will now be an equals sign. So when it comes to thinking about investors, our new guiding equation is below.

1-(1/(PoE/PrV)) = n

Let’s say you have a current valuation of $4M and in the coming year need to raise $1M from a VC firm. This additional $1M would immediately raise your valuation to $5M. Our equation now becomes the following:

1-(1/($5M/4M)) = n

or

0.20 = n

We might not have needed to do all that math to determine that $1M is 20% of $5M, but this practice has real value in understanding the relationship between post-event value and equity dilution.

Say you managed to hit a major milestone in users or revenue in the year leading up to your raise and in-turn your value was raised from $4M to $6M. Our equation is now as follows:

1-(1/($7M/6M)) = n

or

0.14.3 = n

Rather than an investor taking 20% for a $1M investment, they are now taking 14.3%. When it comes to equity investors, reducing your equity dilution and increasing equity value are one and the same and accomplished through increasing your value before entering negotiations.

While functional, these guiding equations don’t factor in things like multiple parties, convertible notes, down-round protections, etc. They are intended to be illustrative in nature. A great tool that can help you better (and more quickly) explore equity dilution is the Own Your Venture Equity Simulator. And if you’re looking for more advanced modeling and valuation expertise, it might pay to drop us a line.

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