TBC: Dilution 101 For Founders

By Jason Yeh
April 11, 2024
Listen on Apple Podcasts

TBC: Dilution 101 For Founders

<p>This is a fantastic episode covering one of the most important insights around fundraising</p><p>‍</p>

Episode Transcript

[00:00:00] Welcome my friends to another episode of the back channel. In the back channel, we like talking about super nuanced elements of fundraising, trying to get in the minds of investors so that you, the founder can be better at fundraising. A lot of these things are esoteric, little bits of knowledge that we think really add to a founder's ability to go out there. Talk to investors and get the job done. Now. There's a concept called fake it till you make it that a lot of founders tend to engage in. It's an okay practice that I think helps in some ways, but done to the level that I see most founders do it too.

It can be quite detrimental. It It can do way more harm than good. And a lot of times people will fake it until they make it and get beyond certain steps and not learn the basics, which is why I've decided to do. This episode of the back channel on something that I bet you, a lot of people pretend like they really really know, but only know maybe [00:01:00] 80% of the way. The thing that I'm describing that we'll go over today. Is dilution. Certainly that's a term.

If you've been in startups, run your own company and thought about fundraising. I have heard of, you've heard about this idea of dilution, you know, at a high level, that dilution is bad. You don't want to be diluted and you kind of know, it means like when you take on investment, you will own less of your company. But if I were to put a gun to your head and say, explain to me, dilution, teach it to me in depth. Would you be able to do it?

Would you be able to do it in a way that most people would understand? I would venture to guess most founders wouldn't be able to. And I think that lack of sophistication can really impact you on the margins, especially as you're getting into negotiations, especially as you're getting to talk to. Venture capitalists about details of a term sheet and where you want this company to go.

So let's walk through it. How does dilution work? Well, I've done this in a variety of different ways. I've written about [00:02:00] it.

I've illustrated it. And today I want to talk you through it. in case some of you are more auditory learners. So, let me put a hypothetical situation in front of you. Let's say you have a company and that company has four shares. As the founder, before you take any money before you give any of your shares away, you own all four shares. The dynamic that you should know about when it comes to raising capital and taking on investors, is this. When they value the company and they say this company is worth, let's call it $4 million. They are saying that the four existing shares the price per share. Is 4 million divided by four.

If you can do that math, that means each share is worth a million dollars 4 shares $4 million. Now when an investor comes in to say, well, I'd like to invest money. I'd like to invest a [00:03:00] million dollars at a $4 million valuation. What they're saying is that I have a million dollars. And you have said shares are worth a million dollars a piece. I would like to buy a new share in that situation.

What is called primary capital? You are issuing a new share, adding it to the full allotment of shares and giving it to an outside party. So in this case, there used to be four shares. But by a new outside investor saying they want to invest a million dollars. They are buying. A single additional share because the price per share again, was a million dollars. Now there are five full shares.

There used to be four. And you, owned all four of them. Now there are five, you own four of them AND an outside investor. Owns one.

Like many of you, my last venture backed startup was a SaaS business. In that company early on, we had the opportunity to sell into a large enterprise, but ran into some walls when they [00:04:00] asked us if we were SOC2 certified. Not only were we not certified, We also found out that it would take our small team a ton of time to get that done.

And so we ended up abandoning the deal. If you haven't run into a situation like that, where a potential customer or investor is asking if you're SOC2, HIPAA, GDPR, or ISO 27001 certified, you probably will soon. But unlike me, you could use a company called Vanta to help. Vanta helps automate up to 90 percent of the compliance work, getting you audit ready in weeks rather than months, and eliminating up to 85 percent of the costs.

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[00:05:00] So in this situation, you have been diluted because you own less of the full amount of shares out there. Now you own four out of five. 80% of the company. As opposed to 100 of the company. That's dilution. Now, since we're on this topic, we're talking about investors, we're talking about shares. I want to point out another situation. Which is another way of getting diluted.

it's often referred to as selling secondary or investing in secondary shares. What that means is an investor comes in and with that million dollars, that same valuation, $4 million valuation each share each of the four shares. Is worth $1 million. So the price per share is a million dollars. Um, let's say they valued it that way.

If an investor came in and said, I have a million dollars. I actually want to buy. And existing shareholders share. I just want to buy one of the existing shares. I don't want to issue more [00:06:00] shares. I want to buy an existing person shares. That means that investors $1 million. I would be given to the founder, me in exchange for one of my shares.

So in this case, dilution happens in a different way. I give up a little bit of ownership, but I do so by giving away one of my shares. So after the investment, there are still only four shares, but now I only own three out of the four shares. I sold one of my shares to that outside investor. So I went from owning a hundred percent of the company to 75% of the company. What's the dynamic there. Well, the thing to realize is that. You were able to bring on a new investor.

The founder was able to get liquidity. You get a million dollars for himself. But the company itself didn't get any what's called primary capital to invest in the business. There's not. A chunk of a million dollars waiting to be deployed and to new employees, to marketing and sales, et cetera, it just went into the pocket. Of one of the [00:07:00] founders, those are two different ways. Investments can happen. In two different ways that you can be diluted. So hopefully you understand the concept of dilution a little bit more. And I hope you'll be able to take that information into your next round of negotiations with the venture capitalist. .

Thanks so much for listening to this, maybe basic, but probably illuminating episode of the back channel. I'll see you next time.

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