The Impact of “Dilution”

 

Many entrepreneurs are surprised at the suggestion that, if all goes well, they will own 10% to 15% of their company at the time of an Initial Public Offering.  That’s quite a contrast from a current ownership stake of, say, 50% immediately prior to a Seed round.  The difference is the impact of dilution due to multiple rounds of financing.

Investor Expectations

Investors have some general expectations regarding acceptable valuation ranges, appropriate issue sizes, and equity ownership (a function of the other two).  Some “rule of thumb” dilution figures are that:

  • Seed Stage financings comprise 20% to 30% of the post-money fully-diluted equity;
  • Series A and Series B financings comprise 30% to 40% of the post-money fully-diluted equity;
  • Later Stage financings comprise 15% to 25% of the post-money fully-diluted equity; and,
  • An IPO is generally for 15% to 25% of the post-money fully-diluted equity.

There is an important “understood” assumption in these rules of thumb.  The company is expected to “top up” its option pool to a standard level each time immediately precedent to a financing.  Typically, an early stage technology company’s option plan is maintained at between 15% and 25% of the company’s fully-diluted equity.  By ensuring these “top ups” occur before a new financing, their dilutive effect only impacts the existing shareholders

Examples

The following two examples give you a better idea of what to expect from the dilutive effects of financings on the VC Path. 

Assumptions for both:

  • Seed Round:
    • Issue Size of US$750,000; and,
    • Valuation will be modest (US$1.5 million to US$2 million), recognizing the caution in the current capital markets and intending to ensure the “right investors” come together and do it quickly.

  • Series A Round:
    • Issue Size of US$3.5 million; and,
    • Valuation will likely be more normal, US$5 million or US$6 million.

  • Series B Round:
    • Issue Size of US$12 million; and,
    • Valuation will likely be, US$15 million to US$20 million (1x to 1.25x projected revenue).

Scenario A

Scenario B

  • strong experienced founding team
  • continuous growth in product development
  • company attracts its intended capital at the most favourable valuations (ie high end of typical range)
  • less experienced team
  • stumbles, but does not fail in meeting its objectives
  • company attracts its intended capital at the least favourable valuations (ie. Low end of typical range)

While these scenarios provide some realistic parameters, actual valuations will depend on the attractiveness of the given investment and the market conditions at the time.

Appendix 1: Capitalization Structure for Highly Successful Team

Issuances of Common Share Equivalents

SAMPLE - Newco
Capital Structure

Start

Option
Plan

Seed
Rnd

Series
A

Series
B

IPO

Equity Ownership (%)

 

 

 

 

 

 

Founder 1

75.00%

56.25%

45.00%

28.13%

17.58%

14.28%

Founder 2

20.00%

15.00%

12.00%

7.50%

4.69%

3.81%

Other Initial Shareholders

5.00%

3.75%

3.00%

1.88%

1.17%

0.95%

Option Plan

 

25.00%

20.00%

20.00%

20.00%

20.00%

Seed Round Investors

 

 

20.00%

12.50%

7.81%

6.35%

Series A Investors

 

 

 

30.00%

18.75%

15.23%

Series B Investors

 

 

 

 

30.00%

24.38%

Public Shareholders

 

 

 

 

 

15.00%

   Subtotal

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

 

 

 

 

 

 

 

Value of Holdings (USD)

 

 

 

 

 

 

Founder 1

 

 

1,687,500

3,675,000

7,875,000

49,804,688

Founder 2

 

 

450,000

980,000

2,100,000

13,281,250

Other Initial Shareholders

 

 

112,500

245,000

525,000

3,320,313

Option Plan

 

 

750,000

1,633,333

5,600,000

56,666,667

Seed Round Investors

 

 

750,000

1,633,333

3,500,000

22,135,417

Series A Investors

 

 

0

3,500,000

8,400,000

53,125,000

Series B Investors

 

 

0

0

12,000,000

85,000,000

Public Shareholders

 

 

0

0

0

50,000,000

Post-Money Equity Value

 

 

3,750,000

11,666,667

40,000,000

333,333,333

Pre-Money Value

 

 

3,000,000

8,166,667

28,000,000

283,333,333

   Subtotal

 

 

 

 

 

 

 

 

 

 

 

 

 

The principal founder’s equity ownership is diluted from an initial 75% to just more than 14% at the IPO.  The value of the equity holdings is US$49 million at the IPO

Appendix 2: Capitalization Structure for Moderately Successful Team

Issuances of Common Share Equivalents

SAMPLE - Newco
Capital Structure

Start

Option
Plan

Seed
Rnd

Series A

Series B

IPO

Equity Ownership (%)

 

 

 

 

 

 

Founder 1

75.00%

53.57%

37.50%

18.75%

9.38%

6.45%

Founder 2

20.00%

14.29%

10.00%

5.00%

2.50%

1.72%

Other Initial Shareholders

5.00%

3.57%

2.50%

1.25%

0.63%

0.43%

Option Plan

 

28.57%

20.00%

20.00%

20.00%

20.00%

Seed Round Investors

 

 

30.00%

15.00%

7.50%

5.16%

Series A Investors

 

 

 

40.00%

20.00%

13.75%

Series B Investors

 

 

 

 

40.00%

27.50%

Public Shareholders

 

 

 

 

 

25.00%

   Subtotal

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

 

 

 

 

 

 

 

Value of Holdings (USD)

 

 

 

 

 

 

Founder 1

 

 

937,500

1,968,750

3,375,000

14,062,500

Founder 2

 

 

250,000

525,000

900,000

3,750,000

Other Initial Shareholders

 

 

62,500

131,250

225,000

937,500

Option Plan

 

 

500,000

1,050,000

3,600,000

30,000,000

Seed Round Investors

 

 

750,000

1,575,000

2,700,000

11,250,000

Series A Investors

 

 

0

3,500,000

7,200,000

30,000,000

Series B Investors

 

 

0

0

12,000,000

60,000,000

Public Shareholders

 

 

0

0

0

50,000,000

Post-Money Equity Value

 

 

2,500,000

8,750,000

30,000,000

200,000,000

Pre-Money Value

 

 

1,750,000

5,250,000

18,000,000

150,000,000

   Subtotal

 

 

 

 

 

 

 

 

 

 

 

 

 

The principal founder’s equity ownership is diluted from an initial 75% to just more than 6% at the IPO.  The value of the equity holdings is US$14 million at the IPO.

As demonstrated, the scenario can be very different if the company is unable to attract a highly experienced management team.  Inexperienced managers may fail to meet the intensive demands of a high growth startup – specifically they may be unable to complete product development on time and need to raise new capital without a completed product.  Investors will “penalize” the company valuation because the product development risk remains.  Once over this “stumble,” the company can get back on track and raise new capital at a step up in valuation.

Source: Ottawa Capital Network


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