Equity dilution is simply the result of supply and demand.
A startup founder begins the entrepreneurial journey owning 100% of the company, or a split of that if there are co-founders in the mix. To grow the business, founders and co-founders often sell an ownership stake in the company, or equity, to investors to raise capital; many will also issue equity to hire and compensate early team members.
Equity dilution occurs when new shares in a company are issued to individuals or entities.
Think of equity shares as pieces of a pie. There is only so much pie to go around, and everyone gets a certain percentage. Regardless of the size of the overall pie, when the number of shareholders increases, some (if not all) pieces/percentages will get smaller.
The value of a shareholder’s equity stake is determined by the proportion of their shares and the value of the company — the whole pie — which will, of course, fluctuate over time.
As if building and growing a new, successful business isn’t challenging enough, founders often struggle with preserving their hard-earned equity throughout the startup life cycle.
Equity dilution isn’t bad per se; it’s part of building a startup. It does, however, make good fiscal sense to have a solid understanding of equity dilution from the moment you start a business to the day you start planning your exit.
What you don't want is to end up owning less than 5% of your business with little reward for years of hard work, which happens more often than you might expect.
This easy-to-follow guide will explain how equity is diluted in fundraising, founder dilution at different growth stages, and how to assess the cost of selling equity.
How Equity Dilution Works in a Startup
At a startup, the most significant equity dilution occurs when the founders raise capital. After founders and investors reach an agreement, shares of equity in the company are issued to those who provide capital to grow the business.
A lot can be negotiated in equity funding deals. Both sides must agree on the funding amount, the company’s valuation, and the equity stake that investors will receive. Terms can include board seats for investors, convertible notes, liquidation preferences, and preferred stock.
The amount of equity dilution that founders experience in the startup life cycle is a function of the number of shares they retain, the total shares in the overall equity pool, and the company’s valuation.
The goal, ultimately, is to increase the value of a startup enough each round so a smaller ownership percentage of a much larger business still increases the founder’s ownership value.
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EXAMPLE - SEED CAPITAL RAISE
Let’s say founders are raising a seed round, and they start with 10M shares. Pre-money, they believe their company valuation is $5M, which puts their stock price at $0.50/share. They wish to retain 60% ownership (or 6M shares), leaving the remaining 20% (2M shares) for employee stock options. In addition, they need to raise $1M in working capital, which they will sell for 20% or 2M shares of current company equity to investors.
At the end of the fundraising round, the goals are:
Ownership | Shares | Price per Share | Ownership Value | |
Founders | 60% | 6M | $0.50 | $3.0M |
Employee stock | 20% | 2M | $0.50 | $1.0M |
New investors | 20% | 2M | $0.50 | $1.0M |
This example illustrates the challenge that founders face when raising capital: a delicate balance of valuation, the number of shares available for sale, the need for working capital, and the investor’s willingness to purchase the equity at the desired company valuation. The startup will need to issue shares to investors and that will dilute the ownership of existing shareholders. If the company valuation increases enough, the value of those shares can offset the dilution.
When raising seed capital, founders quickly learn that company valuations at this early stage are highly subjective and valuation negotiations play a pivotal role in fundraising. Founders might believe the startup is worth $5M ($0.50/share), but investors argue it’s worth $1M (or $0.10/share), for example. Basing a valuation target on good research and business projections is exactly the right move, but as you’ll see, pre- and post-money numbers work out quite differently.
Let’s say the two parties reach a final seed round agreement that values the company at $4M, with a $1M capital investment.
Pre-money valuation
In this scenario, the pre-money valuation is $4M, with an investment of $1M. Investors will get 2.5M new shares at a price of $0.40/share. There are now 12.5M shares. We’ll assume the founders began with their 10M shares split 80/20 between founder ownership and their employee equity pool.
Looking at the pre-money valuation, founders experienced 16% equity dilution and investors own 20% of the company.
The total company shares break down like this:
Ownership | Shares | Price per Share | Ownership Value | |
Founders | 64% | 8M | $0.40 | $3.2M |
Employee stock | 16% | 2M | $0.40 | $800K |
New investors | 20% | 2.5M | $0.40 | $1.0M |
Post-money valuation
With a $4M post-money valuation and an investment of $1M, the pre-money valuation in this case is $3M. Here, the price per share is $0.30, which means investors will get 3.3M new shares of stock for their $1M investment. The total equity pool is 13.3M.
With the post-money valuation, founders’ equity is diluted 20% and investors own 25% of the company.
It breaks down as follows:
Ownership | Shares | Price per Share | Ownership Value | |
Founders | 60% | 8M | $0.30 | $2.4M |
Employee stock | 15% | 2M | $0.30 | $600K |
New investors | 25% | 3.3M | $0.30 | $1.0M |
Again, dilution results from supply and demand.
Founders will aim to use their $1M investment to grow the business and increase the value of the company ahead of the next funding round: their Series A.
Typical Founder Dilution by Funding Round
There’s been speculation over the years about the typical founder dilution in each funding round, and in 2023 Carta confirmed it with data from more than 1,000 priced rounds in the U.S.
As shown above, Carta quantifies the equity that founders give up each round, which aligns with what we assumed was a reasonable guideline for years:
Seed round dilution: 20% (or more if you need more money)
Series A round dilution: 20%
Series B round dilution: 15%
Series C round dilution: 10 to 15%
Series D round dilution: 10%
Here’s another dataset from Index Ventures that shows the average ownership distribution among founders, investors, and employees through several rounds of funding:
This research shows an average of about 28% founder dilution — almost 30% — from Seed round to Series A. Founder dilution from Series A to Series B is about 11%. By Series B, on average founders own less than 30% of the business while investors own more than 55%.
Overall, both sets of data show that founder dilution is far more pronounced in early funding rounds than in later rounds, when startups often raise larger sums of money.
Early-stage founder dilution
Founders are hit hardest by dilution early in the startup’s life cycle. Early investors take a bigger gamble on a largely unproven business — statistically, startups fail at a higher rate between Seed and Series A rounds.
Many startup investors are also looking for a certain return. Venture fund investors, for example, might need an investment portfolio to generate a 5X return usually over 10 years, or a 25% internal rate of return (IRR) over the fund’s lifetime. In a fund with 10 investments, those returns probably come from only one or two businesses that produce a 10 to 100X return on the original investment. With earlier stage investments, dilution is factored into the desired ROI.
Here is what VCs might expect on a given investment, by funding round:
ROI | Minimum IRR | |
Seed | 10X+ | 80% |
Series A | 8X | 60% |
Series B | 5X | 50% |
Series C | 4X | 30% |
Series D | 3X | 25% |
Founders generally have far less leverage to negotiate higher valuations in their early stages, regardless of their view of the startup’s potential value. Even with traction, they will get a deal that aligns with a VC’s math.
Though some entrepreneurs come to regret jumping aboard the fundraising train early, raising money from angels, seed investors, or venture capitalists isn’t always a bad idea. Certain businesses need to raise equity capital to get the company off the ground; other startups can bootstrap all the way to an exit without ever drawing on outside funds.
Typically, at some point startups require capital to spur growth. It’s more common than not for startups to blend funding from a variety of sources, including:
Friends and family
Grants
Government programs
Crowdfunding
Angel investors
Incubators
Venture capital
Venture debt
Debt capital (loans)
Private equity
Most outside funding sources are dilutive — they either require equity or can have an equity component — the exception being most loans, grants, and government programs.
Nevertheless, too much dilution too soon can have an outsized impact on what a founder takes home at journey’s end. Fundraising is a long game in which each priced round affects the business’ future outcomes, and equity capital raised early on will be the most expensive.
So, the best strategy is to delay equity dilution as long as possible and build the business on your own. The less you need to take money from investors, the more cash you’ll walk away with when you reach an exit.
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The Real Cost of Equity for Startups
What’s that equity you’re giving away worth? In addition to reviewing capitalization tables and all the terms of the agreement, it’s smart to estimate your costs in an equity funding deal.
Ideally, you’ll want to calculate your cost of equity just as you’d calculate your cost of debt before taking out a loan. However, this is exceedingly difficult at earlier stages. The value of that equity will change dramatically before you reach an exit event like an acquisition or IPO, which could take years and many more rounds of funding.
Accurately forecasting your cost of equity in a funding round is like creating a perfect March Madness bracket; still, you should always assess your cost of capital.
Understanding your cost of equity
A simple approach is to look at the return on the investment through the lens of a capital provider when your business presumably makes a successful exit — their ROI is your cost of equity.
Here are two ways to do this:
1. Run a simulation
This can get quite complex depending on your assumptions and the startup valuation method you choose to explore, as well as the number of funding rounds you expect. You’ll make an assumption about your startup’s growth potential to project an exit value, then work backward to calculate the investor’s return multiple.
We built a startup equity dilution calculator that makes this easier. Our cost-of-capital models are based on data we’ve collected over our decade-plus of funding startups.
Try the Startup
Equity Dilution Calculator
You’ll see a projection of your ownership value at exit after raising equity, as well as a projection for a non-dilutive capital raise. In this side-by-side comparison, you can see how much greater your ownership value at exit could be when you get the same amount of capital to grow your business without ceding equity. You can also use the data table that’s generated to look at the investor’s ROI.
2. Look at public data
Data from startups that have gone public can be informative. Though you probably won’t be able to tell how much an investor contributed in each funding round, you can dig into the company’s ownership structure and the total amount raised. Think of it as a weighted average cost. This approach gives you perspective on your cost of equity if you’re wildly successful.
Example
Tableau, founded in 2003, raised a total of $15M before going public in 2013. Its Series A/B investor, who contributed $15M in 2006, ended up with 38% ownership and 20M shares at the time of IPO. Tableau’s IPO price was $31. Let’s assume there was one round between its Series A and Series B. Seven years later, that investor got back $620M, which translates to a 40X investment return.
Hidden equity dilution costs
Equity dilution doesn’t hit entrepreneurs in their wallets only upon exit. The effects of equity dilution can start to snowball sooner, making it more challenging to grow a successful business and to achieve desired outcomes.
Here are three hidden costs of equity dilution that founders often don’t anticipate:
1. Reduced ownership and control of the business
As new investors become major stakeholders, founders’ ownership and control of the business will decrease. Sometimes, investors also sit on the board. In making business decisions and choosing where the company goes next, founders have a lot more people to answer to, so they don’t always get the final say. It’s not uncommon for founders to cede an active leadership role if majority stakeholders demand it, or to make an exit earlier than was planned.
2. Fundraising challenges and down rounds
If founders have a smaller ownership stake, it could influence their ability to negotiate favorable terms in future fundraising rounds. Investors may perceive a lower level of commitment from founders with reduced ownership. Down rounds — in which an equity raise causes the price per share to go lower than in a previous funding round — aren’t ideal either. If the company’s growth and valuation fall below expectations, founders can experience more significant dilution. This can also cause investors, employees, and the market at large to lose confidence in the business, making it less attractive to internal and external audiences alike.
3. Talent acquisition and retention
Stock options can be a powerful tool for acquiring, retaining, and motivating startup employees. If shares become overly diluted in fundraising rounds, some employees may question the long-term success of the company. Replacing lost employees can be just as hard as hiring for growth when the company stock is so diluted it offers what appears to be very little additional incentive. In a small organization, a few churned employees can seem like an exodus.
Striking a Balance
Since 2010, Lighter Capital has helped more than 500 early-stage startups grow with non-dilutive capital. Some of our portfolio companies came to us fully bootstrapped; others have raised or plan to raise equity capital, as well. Nearly every founder who’s grown their business using our non-dilutive capital solutions shares the same feedback with us: “I had no idea how expensive equity is.”
There are certainly benefits to raising equity at the right times and for the right reasons, but striking a balance between raising capital and preserving ownership can be tough. It’s always best to keep it simple, so focus your energy on these three things: Grow a healthy and sustainable business, make strategic funding decisions, and negotiate to get a fair deal.
Additionally, it’s valuable to understand the concepts and cost benefits of other capital sources that can help fuel your startup’s growth with minimal share dilution. Armed with the knowledge of diverse funding options and strategies to retain equity, you’ll be prepared to lead your business toward success — and a lucrative exit.
Find the right funding strategy for your startup
Most entrepreneurs see venture capital as the holy grail of funding solutions, but fewer than 0.05% of U.S. startups ever raise a VC round.
There are other startup fundraising options, and some of them might be more advantageous for your business. This guide will help you decide what kind of capital to raise, when to raise it, and what you need to get it.