Introduction

Dilution is an unavoidable byproduct of equity financing. It gets a bad rap despite in most cases being a normal sign of growth. If you’re raising external equity financing, the simple truth is you should be prepared for ~10% dilution per round. If you’re not comfortable with this, consider raising less capital, raising from different capital sources (e.g. debt), or not raising until you’ve bootstrapped the business to a place where you can negotiate better terms. But if you’ve decided it makes strategic sense to raise external capital, here are some tips on how to deal with dilution.

First, a quick definition: dilution refers to the reduction in the ownership percentage of a company's existing shareholders due to the issuance of new shares. For our purposes, we’re considering how early stage founders’ ownership positions are diluted over time with issuances of new shares to equity investors.

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Decide how much to raise

Before you forecast dilution, you need to determine how much capital your business actually needs to get to the next milestone (typically a growth target that will enable you to raise another round). When determining capital needs, you should take into account the resources needed to reach the next milestone, including headcount, systems costs, marketing, etc. and the monthly cash burn required for these expenses.

We always recommend including additional buffer. So if you believe you can reach the next milestone in one year with $120k in cash, burning $10k per month, consider raising more than $120k in case your expenses are higher, your growth is slower, or it takes longer to raise the next round. Generally speaking, you want to secure at least a year in runway, though it’s better to have the optionality of 18 - 24 months of runway.

We recommend building a multi-round operating model to forecast revenue and expenses using the proceeds of the raise and future raises, even though those variables and inputs will change dramatically over time. From there, you can use sensitivity analysis to tweak assumptions and test their impact on outputs like runway and burn, and adjust the model.

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Calculate your post-money valuation

Pre-money valuation is your company’s enterprise value prior to taking on investment, whereas post-money includes the investment itself. The higher the pre-money valuation, the less dilution the existing shareholders will experience.

There is no silver bullet for setting your valuation - at the earliest stages, before revenue multiples are relevant, valuations are likely to be determined by what the market is “demanding”, in addition to factors including your geography, industry, and business model. If you’re a pre-revenue company in a down-market, the reality is you’ll almost certainly have to raise at a lower valuation than you would be able to in good times unless you have exceptional proof of concept, experience, a proven track-record, or some other competitive advantage that investors can hang their hat on. In a bear market, it may make sense to bootstrap until you generate revenue and de-risk the business model enough to raise at a higher valuation. The final valuation you settle on will almost certainly be determined by supply-and-demand (e.g. what investors are willing to give), but you should establish your target before initiating investor discussions.

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Calculate dilution

To project how much dilution you’ll take on, first calculate how much of the company you’re giving away by dividing the investment (”money in”) by your post-money valuation (pre-money valuation + investment). From there, you can figure out the rest.

Your pre-raise ownership: 100%
Money in: $500,000
Pre-money valuation: $5,000,000
Post-money valuation: $5,500,000
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New investors ownership: 9.1%
Your post-round ownership position: 90.9%
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If you're raising an institutional round, ask funds for their target ownership

Founders should ask each fund about their ownership target during the first call, whether they're a potential lead or a follow on. If there isn’t a match between…

• Your valuation, how much you’re raising, and therefore the % you’re willing to give away
• And how much ownership that investor targets at your stage

…then there’s no point in continuing the discussion. If it’s an investor you are particularly interested in because of their domain expertise or brand, you either have to adjust your expectations, test their flexibility, or move on.

Some funds have no flexibility on ownership targets, as it’s a core component of their investment mandate and LP agreement, whereas others have flexibility. Most funds treat ownership targets as guardrails, targeting ranges such as 5% - 8%. It should be fairly obvious from their answer to your question where they fall on this spectrum, but if not, dig in and explicitly ask. Ownership targets will be higher for funds that lead rounds at your stage, versus those that follow on.

Side Note: in general, early stage founders tend to be far too reticent to ask questions about investor business models and economics. Their business models determine a lot, including future incentives. Besides dilution, you should also ask if they typically invest their pro rata (the amount required to maintain their ownership %) in future rounds, and what ownership percentage they target at exit. At a minimum, such questions demonstrate an interest in and knowledge of venture business models, showing you’ve done your homework and are diligently considering incentive alignment.

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Forecast dilution over the lifetime of your company

It can be hard to predict how dilution will affect your ownership position as a founder 3, 4, 5 years down the line and multiple equity financings later. When a fund considers investing in a new company, they often run an exit analysis to forecast how their ownership position obtained at T0 will change over time with additional financings, including whether or not they participate in future rounds to protect their positions (aka exercising pro rata).

We highly recommend founders do the same so they can forecast ownership at exit, prepare for dilution, and adjust expectations over time as assumptions change (# of financings, capital source, growth, etc). Such an analysis will help you determine the amount of dilution you’re comfortable accepting today, with an eye toward your eventual ownership position, not just your ownership position post-financing.

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Consider alternative funding options

If forecasted dilution is too high, consider alternative funding options such as debt financing, convertible notes, or SAFEs (Simple Agreement for Future Equity), which may result in less dilution. Note that SAFEs and Convertible Notes just kick the dilution can down the road. You should include such instruments in your Pro Forma Cap Table, and expect them to convert and dilute your position. SAFEs, for example, will convert to shares at the next qualified financing round, and are usually set with a valuation cap and/or discount rate, which determine the valuation at which the investor can exercise and therefore their ownership and your dilution. There are many resources on SAFEs and convertible notes, including differences between the two (check out Carta’s here.)

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Conclusion

Forecasting dilution and planning the terms of your financing round is a crucial part of the fundraising process. It is important for founders to understand the impact of dilution on their ownership stake and the company's valuation. There's a lot of capital raising software out there, including Flowlie, that can help founders answer some of these questions. By carefully considering the amount of capital needed, the pre-money valuation, and the terms of the round, founders can minimize dilution while raising the necessary capital to grow their business.