When a startup (or company) is created, capital is provided, which, for example, in the case of Spain, by law must be at least €3,000, and this capital is divided into “shares” that have a “nominal” value of usually 1€ or other suitable value. We'll take the case of 1€ to simplify the explanation. If each share is worth 1€ then the company will have issued 3,000 shares and these will be distributed among its founders or entrepreneurs as established between them. If Pedro, one of the founders, has 1,600 shares, then he will have the “ownership” of 53.33% of the company (1,600 shares/3,000 shares). As soon as entrepreneurs need more capital, because with the €3,000 they have contributed they will not be able to go very far, they must “open” the company's capital to third party investors, or in other words, ask for more capital in exchange for issuing new shares of the company. The moment investors enter the company's capital through the issuance of new shares, there will be a “dilution” for entrepreneurs. The dilution in a startup, for its entrepreneurs or founders, is nothing more than owning a smaller proportion of the “pie” as a result of the entry into the company's capital of new partners. Following the example, let's suppose that the startup decides to issue 1,250 new shares at a post-money valuation of 1.0M€... each new share issued will have a value of 850€. Those investors who put this million Euros into the company will get hold of the new 1,250 shares, so now the company's capital will have increased and there will be 3,000 shares issued at its foundation, plus the 1,250 shares, in total 4,250 shares. Therefore, Pedro will now own 37.6% of the startup since his original 1,600 shares will not have changed, but the total number of shares into which the company's capital is now divided will have increased to the 4,250 shares mentioned. Another way of saying the same thing would be that there is a total dilution of 29.4% of the existing capital in the company, which emerges from the following account: 1,250 divided by 4,250. Thus, (1-0.294) x 53.33% = 37.6% gives us the% of “ownership” that Pedro will now have in the startup. So far the mathematics of dilution, which are truly simple. Pero behind this mathematics there are questions of political and economic rights, and others of the “emotional” type, which the accounts do not reflect and which are the truly important ones when it comes to analyzing the dilution of founders in startups.I start with the emotional factors... many entrepreneurs insist on trying to achieve a valuation that for many investors may be too high at too early stages of companies, when what you have to do is try to be very efficient in the use of capital and go for the minimum necessary to find the product-market fit, trying to break even very quickly and then look more calmly for a round A that allows climbing. In this way, the initial valuation discussion becomes less relevant, or you can go for a convertible note with a discount in the next round in order to avoid discussing the valuation altogether. And even if the initial dilution is a little higher than expected, equity can be recovered later through an “equity pool” for founders and key managers when the first professional VC enters. The next topic in order of importance is be as cautious as possible when giving up certain prerogatives to you, the most infamous of all are the so-called “liquidation preferences”... I am not going to go too far because it would be the subject of another article and the only recommendation I will make regarding these is to never accept a clause beyond what is called “x1 non-participating liquidation preference”. This type of clause has the power to substantially change the distribution of profits that can be generated by the sale of a company in favor of investors, and strongly distort the economic rights of the entrepreneur, beyond what their percentage of ownership of the company would indicate, which is why it is the most important clause to study on any Term Sheet. Also, as I mentioned before, The entry of investors into the shareholding of a company entails a series of political prerogatives in the form of vetoes of entrepreneurial decisions. Through these vetoes, investors can disproportionately influence company decisions, forcing entrepreneurs to follow paths they would not have chosen otherwise. So you have to choose very well which investors to add to your project, especially in the earliest stages, trying to choose between those who are not so interested in playing an excessive role in the management of the company and who may be more aligned with entrepreneurs in terms of vision, management style and future prospects of the company. And since no discussion about dilution can end without defining some basic ideas of what the more or less standard dilution values in the venture capital industry can become, In the attached infographic, entrepreneurs can get a rough idea of what they can expect at the different stages of a startup's growth. It should be noted that this infographic reflects amounts and valuations more specific to the American market, and - especially for startups in the early stages - the valuations may be higher than those observed in operations in the Spanish ecosystem. [caption id="attachment_16012" align="aligncenter” width="640"]
Infographic dilution of a startup. Prepared by Mark Suster, (@msuster), a two-time entrepreneur, currently working in GRP Partners[/caption]If you have questions or think we can help you in finding private or public capital for your startup, don't hesitate to get in touch contact us.
