Managing founder dilution through modeling and strategy.
For most founders, ownership comes in the form of equity, which is typically represented by a specific number of shares (ie stock) of a company once the business is incorporated. For purposes of this article, we use a C-Corp as the legal entity type for the company example. A founder starts out by owning 100% of the company’s shares, and thus starts with complete control. By authorizing and issuing shares, ownership of the company can be distributed through the sale of stock or option grants to persons or entities other than the founder, like investors, employees, advisors and other service providers. The sale of stock can generate much-needed cash for operations and stock options can be useful for attracting talent. As equity is distributed, however, ownership begins to spread among shareholders, causing a reduction in the founder’s equity. This spread of equity also means potential loss of control for the founder.
A company might raise multiple rounds of private funding in order to reach the company’s growth and scale goals. Funding rounds can be accomplished by selling stock or by selling convertible securities (securities that convert to stock at a later date automatically or upon some triggering event). Later rounds may involve the sale of preferred stock to a VC, typically in a Series A transaction. While convertible security holders, as well as option holders, are not current owners of the company, their post-conversion shares must be carefully considered for purposes of predicting dilution. Preferred shares typically come with special rights and privileges, which normally impact a founder’s control.
Stock incentive plans are created by setting aside a certain number of the company’s shares to distribute to employees and service providers. One of the most common methods of distributing such shares is through the use of options, or the ability of an option holder to purchase shares in the future at a price set when the options were first granted. While option holders are not current owners of the company, their potentially exercises options must be accounted for to get the full equity ownership picture.
Dilution occurs when the sale of new equity reduces the ownership of existing equity, typically on a pro rata basis. Dilution also occurs when convertible securities convert to stock or option holders exercise their options and become shareholders. Dilution reduces the founder’s ownership in specific ways that can be calculated and predicted. With dilution comes the possibility of losing voting control in the company so understanding the calculations are critical for a founder.
There are a number of important considerations for founders when modeling dilution, including how many shares have been authorized and issued, the number and size of planned rounds, the fundraising vehicles used and their terms, and how much stock is distributed in each round. This is coupled with the number of outstanding options grants. For founders, this often requires a delicate balancing act among talent, investors and the financial needs of the company. The company’s cap table should reflect all of these considerations.
Founders who are raising money through the sale of stock or convertible securities, or are granting options through their stock incentive plans, cannot entirely prevent dilution but they can manage dilution in a number of strategic ways:
1. Plan rounds well in advance. Specifically, know the amount of each round and anticipate the company’s valuation at each round as best as you can.
2. Limit early distribution of shares. For instance, give options to only those early contributors, employees and advisors who are the most valuable to achieving the company’s goals. Also, give options in smaller amounts that vest over a significant amount of time. It is important to reward early contributors, however, the numbers can add up fast.
3. Limit the amount of equity available per round. Especially in early rounds, founders should be careful not to give away too much equity. The tendency is often to see a large amount of equity as a never-ending supply but that’s not the case and lots of small stock and option grants overtime can easily contribute to the loss of founder control.
4. Consider making stock incentive plan shares non-voting. By pulling shares out of the company’s plan from the voting mix, it can be a little easier for founders to maintain control. However, it is common for all non-voting shares to be converted to voting shares at the time of a Series A, so the non-voting shares may wind up being voting shares in the end.
The above strategies normally require accurate modeling of the company’s cap table, which can be done in stages. It is only when a founder sees the various dilution scenarios in clear and easily understandable numbers that he/she can make the best decisions about how to manage equity dilution.
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