Equity Dilution and Early-Stage Startups: Everything You Need To Know

By: MassLight Team

For early stage founders, making time-sensitive fundraising decisions is crucial for propelling their companies forward. However, it is important to understand the long-term implications of these decisions. One way to do this is by understanding how much money is truly needed and protecting ownership by not raising more than that amount. Early money is often the most expensive and may come with too many strings attached. It is also important to learn about the key terms and instruments of funding, as there are tools available to help forecast and understand long-term equity dilution. By being aware of these factors, early stage founders can make informed decisions about fundraising that will benefit their companies in the long run.

When entrepreneurs have a successful fundraising round, they often celebrate and reflect deeply. While the influx of money provides room to grow, it also comes with a cost of losing control and flexibility later on. To avoid this, it's recommended to only raise as much capital as needed. However, determining the right amount can be challenging. If you raise too much, you may give away a larger portion of your company than necessary. On the other hand, if you raise too little, you risk running out of cash before achieving necessary milestones. Understanding the complexities of financing instruments like convertible notes, SAFEs, and equity rounds can also be overwhelming.

If you're wondering how to approach fundraising, here's some advice from experienced startup founders and advisors. First, begin with solid forecasting and calculations, and seek help navigating the legal terminology. One important recommendation is to raise only the amount of capital you truly need. Despite varying opinions, the optimal amount of fundraising depends on factors like economic conditions and investor interest in your startup.

From a dilution perspective, it's evident that you should take as little outside capital as possible. The money you raise in the early stages is typically the costliest funds you'll ever take, as initial backers receive equity when your company has the least value. Thus, each dollar invested purchases a proportionally larger stake. This is applicable even if you employ an investment vehicle like a convertible note or a SAFE, which postpone a decision about how much equity investors will receive until a later date.

Venture Capital

Using convertible notes or SAFEs to raise pre-seed funds from friends, family, and angels is a smart move because it allows you to start quickly without valuing your company precisely. Moreover, note and SAFE holders typically receive a discount when you do your first priced round due to the additional risk they take. However, don't rely on these instruments for too long. As the amount you raise through these instruments grows, so does the pressure to raise a priced round with a high valuation. For instance, if you have raised $500,000 through SAFEs or convertible notes and can only command a $3 million post-money valuation when it comes to a priced round, your note holders will own more than 20 percent of the company, taking the discount into account.

A SAFE or a convertible note allows raising money without assigning a specific value to your company or determining the investor's equity. A SAFE provides shares at a discounted rate during the first priced round and does not have a maturity date or interest, unlike a convertible note. Although there are some differences between the two, they do not significantly impact the startup's ownership structure in the long run. To decrease risk, it's crucial to plan out the critical milestones. SAFEs, which were pioneered by Y Combinator, have become increasingly popular due to the availability of free templates. Using a YC form can also save on legal fees.

Using caps can be a helpful guide when considering convertible notes or SAFEs as a funding option. A cap acts as a safeguard for note or SAFE holders against dilution that can result from a startup raising a priced round at a high valuation, guaranteeing a minimum equity stake in the future. For example, if the cap is set at $5 million, a note or SAFE holder would own the same percentage of the company for any amount raised at or above that cap. Although founders may not like caps, they are becoming increasingly common in deals, and can provide a rough estimate of the impact on dilution. It's worth noting, however, that raising below the cap amount will lead to more dilution. Another piece of advice: caps can be used to gauge the effect of SAFEs or notes on equity.

To build your startup team after securing funding, be cautious of costs by limiting the size of your employee equity pool. Many venture capitalists advise against allocating too much equity as it can lead to dilution of ownership for both you and your investors. Typically, startups set aside 10 percent to 20 percent of equity for option pools and it's crucial to carefully distribute it among key employees. For example, a VP of engineering or head of sales joining at the earliest stages may receive between 1 percent and 2 percent, while other senior roles may receive half a percent.

A marquee investor expresses interest in your company but wants the option to increase their stake in future rounds, referred to as super pro-rata. Seed investors aim to have winners in their portfolio and therefore prioritize investing in them. While standard pro-ratas are common and provide protection against excessive dilution, super pro-ratas can discourage new investors. According to Cardamone, many later-stage funds require at least a 10 percent to 15 percent stake and may avoid investing if a super pro-rata arrangement is in place. To address this, he suggests negotiating with investors and reminding them of the potential consequences of such an arrangement on future rounds. Ultimately, most investors may agree to forgo super pro-ratas to avoid hindering future investment opportunities.

The key advice we've discussed can be summarized as follows: thoroughly comprehend the nature of your commitment, contractual terms, and the numbers involved. According to Cardamone, many founders become too eager to secure funding and sign without fully considering the consequences. Fortunately, there are online resources like Capital Calculator and Captable.io that can assist with the details of fundraising and dilution. Once you've completed your research, it's best to act swiftly and not spend too much time optimizing for a slight increase in percentage or funding. At the beginning stages of a startup, it's crucial to attract the right people and secure smart money quickly and with minimal difficulties, as per Cardamone. Ultimately, your priority is to run your startup efficiently.

Ready to bring your startup to the next level? Apply to MassLight’s next batch. MassLight supplies capital and a dedicated tech team. We take equity in return. Have questions? Refer to our FAQ page.

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