The Misunderstood Parts of Dilution and Venture Math
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When Aaron Levie’s company Box IPO'd in 2014, he owned just 5.7% of the company.
Shocking?
Nope.
That's the reality of venture funding and dilution. The past 2 historically good years have made it seem to founders like anything BUT microscopic dilution is blasphemy. Under these circumstances most founders barely even know how to calculate dilution.
But these circumstances, well they are changing (rapidly), and a more sober reality is about to hit MUCH harder.
Ready to learn?
First - what is dilution?
Dilution is the decrease in ownership founders experience when they give away / sell shares in the company. Some common reassons to give away / sell shares:
- They give shares to employees / advisors as part of their compensation.
- They sell shares to investors in exchange for cash to operate the biz
- They sell personal holdings of shares for liquidity
Dilution is a crucial part of making a thriving innovation engine run because venture-backed companies generally require upfront investment before they can generate significant profit.
The tradeoff of dilution or cash allows you to hire talented employees you can't afford, it allows you to invest in infrastructure, and overall create the machine that generates high margin cashflows in the future (the goal at least).
In the polarizing world we live in, I often see a highly divisive portrayal of dilution. It’s described as a poison forced on founders by evil investors.
Don't get it twisted - dilution is the result of employees and investors taking on significant risk to fuel the growth of startups. This is a symbiotic game. Respect should be paid to both sides of this equation and there IS a middle ground.
Next - how do you calculate dilution?
This is where most founders stumble. They SAY they know how to calculate it but if you asked them to explain, 90% of founders would answer:
"Oh it's easy! You divide this by that... and uh..."
Before you run any calculations, here's the dynamic that will help explain what is happening in dilution:
When a VC invests in a company, the company creates NEW shares to sell to the investor.
So the math you run has to determine how many new shares the VC buys
Let’s walk through an overly simplified investment example to illustrate the important concepts.
The setup
- A newly formed company has 4 shares
- At the beginning, the founder owns all 4 shares in the company (100% ownership)
- Next, some investor agrees with the founder what the company today is worth today. They set the valuation at $4M
- With 4 shares in total worth $4M, the price of each share is $1M per share ($4M ➗ 4)
The investment
- Now, the VC wants to invest $1M
- With that money, she can buy 1 share at the price determined above ($1M per share)
- The share she buys with her investment is a NEW share. There are now 5 shares in the company
- The founder still owns the same 4 shares she started with. But because there are now 5 total shares, Her ownership goes down from 100% to 80%
- The venture capitalist owns 1 out of the 5 total shares (20%)
- Dilution conclusion: the founder was diluted by 20% in this round
Also misunderstood? Dilution planning
Much of the despair around dilution comes when founders don't model out ownership levels and don't know how much to expect. The famous quote “happiness is the difference between expectation and reality” applies.
Step 1 of solving for dilution planning is learning the math (done!)
Step 2 is learning common levels of dilution (still work to do…read on)
Common levels of dilution
In sober markets, most VCs would agree that modeling out 20% dilution in a venture round is a fair and average target.
I usually advise founders the following:
If you can get closer to 15% dilution you're doing better
If you're exceeding 25% dilution...it's not so great
Disclaimer: dilution is a zero sum game in that if founders are taking on very little dilution, investors ownership levels suffer. But if investors own a lot, founders are being heavily diluted. The best venture-backed companies have founders and investors balanced at a fair level. You want both sides excited and engaged!
A Dilution Tool
Some of you read my example above and kinda *nods and smiles* through the whole thing. No worries, you’re a founder, a builder, not necessarily a mathematician.
Knowing that would be the case, I put together this Dilution Tool that walks through dilution math (grab it for free here).
Beyond the explanatory glossary and stage-based dilution calculator, it also has a sensitivity table that you can use to model out your round expectations. All should be very helpful in solving the planning and expectations problem.
Added complications: fallout from the 2020-2022 hyper bull startup market
Pop quiz... do you know what the added dilution risk is when a company raises a SAFE with an overvalued valuation cap?
This is the scenario we are entering at the time of this essay writing (May 27, 2022…on a plane to NYC :P)
No more content here, just teasing the next essay that will break down the topic!
Btw - if you're curious why Aaron Levie was diluted so heavily, check out the number of rounds and amount of money he raised.
$414M via 11 different raises
23% dilution 11 times (.77 ^ 11) will reduce a 100% ownership down to 5.6%
$414M via 11 different raises
23% dilution 11 times (.77 ^ 11) will reduce a 100% ownership down to 5.6%
Pop Quiz #2 - Can you guess what Box’s seed valuation was? That was the question I posed on Twitter and guess what… Not only did Aaron give us the official answer, but also Mark Cuban, who did the seed round, put in his two cents as well!
For those keeping score, Box raised that first $350k from Mark Cuban at just over a $1MM valuation. And you know what? Aaron was stoked about it!!