This Summer, I’m working with The Capital Factory and helping out a number of young companies here in Austin, Texas. The purpose of this spreadsheet is to show the effects and calculations for ownership dilution over the course of three rounds of investment for an example company. There is no rocket science here by any means; that said, the first time I had to figure this stuff out was a real pain in the butt…so hopefully this speeds the process for others.
For the sake of simplicity, we will assume there are 3 founders with arbitrary ownership percentages; we will also assume a total of two investors and 3 rounds of funding: seed, series A, and series B. Of course, these assumptions can be changed as necessary to make it match your actual situation if you want to plug in your numbers / facts.
Will will also assume a $5m exit (liquidation) as might happen if the company were acquired. We’ll discuss it further but it’s important to say right up front that you’ll never make this amount of money from such an exit with such ownership. This is a theoretical MAXIMUM because it does not take taxes, legal fees, potential preferences, etc. into account.
In subsequent versions of this spreadsheet, we will consider how the “preferences” of preferred stock can affect the outcome. For now, this spreadsheet assumes everyone participates equally as if everyone owned common stock. When a company starts, the founders use some means to determine initial ownership: who’s idea it was, amount of personal capital invested, drawing straws, etc. The actual means used to determine initial ownership is immaterial to this analysis.
Many times, founders will not proactively allocate an option pool early in their company’s life. Whether you do it now or later, most investors will require the creation of an option pool BEFORE they make any investment because, simply, they do not want to be instantly diluted by pool creation immediately after investing. In the case of later rounds, it’s very common for investors to require an expansion of the pool up to 10%-15% ahead of their investment, depending on the situation.
In this example, we will create a 10% option pool at the point of founding. You can see that the Founding Stage total is made up of the three founders and the option pool = 100%
Here, our example company is taking a $20,000.00 seed-stage investment at a $400k pre-money valuation (value of the company before you take any money). It is not surprising, then, that the “post-money valuation” is the amount invested PLUS the pre-money valuation. This post-money valuation is exact value of your company immediately after completion of the financing and will be used to price stock options.
For each column / financing: pre-money valuation is on the left; below that is the amount raised; post-money valuation is on the right.
In the seed investment, you will be selling 4.76% of your company to Investor #1. This is simple math you can see in the spreadsheet cell. You can also say that everyone in the company will be diluting by 4.76%. You can see that Founder #1 “dilutes” from 37% ownership to 35.2% of the company, and so on.
Series A Investment
in the series A investment, our example company has done well enough to nearly double it’s pre-money valuation to $700k. The company has determined that it makes sense to raise $250k – usually that means a balance between necessary capital to reach the next set of financeable events and dilution to employees and investors.
This Series A investment represents a sale of 26.3% of the company to Investor #1 again – they must like what they’re seeing in our example company!
Note, however, that Founder #2 has decided to step up and invest $15k themselves. Such an investment is wholly predicated on the founder, the investors, and the current situation – there are no hard and fast rules to founders participating in subsequent financing although most investors would see it as a great show of enthusiasm and more “skin in the game” for the founder (both good).
For $15k, Founder #2 owns 17.7% of the company after Series A versus 16.1% if they had not made their series A investment: an increase in ownership of 1.6% instead of any dilution.
Investor #1 now owns 28.2% – and in this example – more than any individual founder. This is not an uncommon situation and over time and various fund raising, you should not be surprised to see this happen.
Series B Investment
This round is similar to Series A in terms of mechanics; here, valuation has more than doubled and the amount being raised is $850k. Employees have probably been hired; business model and go-to-market has probably been proven out. In a typical Series B, the money raised goes to scale up the mostly-proven business.
Founders are not investing in this round – and that is common as well. At this point, the price the founders paid for their stock (potentially zero) is significantly less than what Series B investors are paying; that coupled with the fact that the foudners will not materially change their ownership with small investments typically means that founders / early employees will not participate in late rounds of financing.
Dilution is 36.2% overall and investor #1 will typically have “pro rata” rights to invest an amount in a subsequent financing required to maintain their ownership percentage. In this case, Investor #1 must invest another $240k to maintain their 28% ownership in this company. Investor #2 leaves the Series B investment with 26% of the company that is now worth $2.35m.
Liquidation (acquisition) of the company
Ignoring all tendency to describe the relative rarity of such an event, “liquidation” doesn’t have to mean acquisition as we will see when we discuss term sheet structure; in our example, it does.
As we mentioned before, we’re going to assume a $5m exit (feel free to add some zeros when you’re alone). This represents another “doubling” of value from our series B investment. Note that it’s an entirely different conversation as to what is “good” versus “bad” from a returns perspective. For now, assume that it’s good enough to allow it to happen.
An Remember: you’ll never make this amount of money from such an exit with such ownership percentages becuase this spreadsheet does not YET taxes, legal fees and potential investor preferences into account.
In our next version we’ll start looking at the effects of long-term/short-term capital gains, some nominal fees, and investor preferences. This is where you’ll start to see how certain terms can materially affect the outcome of your company; we’ll also use that opportunity to define common term sheet terms.