Capital is the lifeblood of any growth business. Raising sufficient capital enables you to fund the development of your product before you start generating revenue, get your offering to market faster, and scale the business once you’ve operationalized it.
But many approaches to raising capital require you to give away a portion of ownership in the business you’ve worked hard to get off the ground. The more equity you give away to investors, the more your share of ownership becomes diluted. Raising capital without diluting too much of your ownership requires a delicate balance.
How Ownership Gets Diluted—And Why it Matters
In the earliest stages, your own financial resources may be enough to fund your new venture. Eventually, though, you’re going to need an infusion of capital from other sources. If you can raise enough seed capital through loans, grants, or crowdfunding sites like Kickstarter or Indiegogo, you can postpone the need to give away equity in the company. But at some point, you may have no choice but to turn to equity financing.
When you seek funding from angel investors or venture capital firms, you must be prepared to give up a portion of ownership in exchange for their financial backing. And every time you offer equity to an outside investor, you dilute your ownership. Dilution of ownership refers to the reduction in current stakeholders’ equity that occurs each time you issue additional shares.
Let’s assume you start out as the company’s sole owner and you decide there will be a total of 20,000 shares in the business. If an investor requires a 20 percent stake in the company in exchange for the amount of capital you’re asking for, that investor will now own 4,000 shares, leaving you with the remaining 16,000 shares, or 80 percent of the total.
Now let’s say that in order to attract high-quality talent to drive your business forward, you need to set aside additional shares in a stock option pool to provide financial incentives to key hires. So you create an option pool of 1,000 shares. Now your ownership has been further diluted to 15,000 shares, or 75 percent of the total. And that’s only after one fundraising round.
Ownership dilution certainly matters from a financial perspective. After all, if you end up selling your business for $50 million down the road, but you’ve given away 40 percent equity to investors and key employees along the way, your share of the sale will be much lower than if you had somehow managed to retain 100 percent ownership.
But managing ownership dilution isn’t just about money. Once you’re no longer the sole owner of your business, you’re no longer the sole decision-maker either. As your ownership share becomes diluted, so does your degree of control.
Avoiding This Common Ownership Dilution Pitfall
To avoid losing too much of a financial stake in your company and too much decision-making power, it is important to steer clear of the fundraising pitfalls that can lead to over-dilution of your ownership.
One of the biggest mistakes is raising more money than you really need. The more capital you raise, the more equity you will have to give away, especially in the early stages. While it can be tempting to raise as much money as possible, it’s more prudent and financially advantageous in the long run to raise only as much funding as you can put to effective use in the short term.
For that reason, each round of fundraising should be specifically designed to help you reach one or more major milestones—at which point, you will be ready for the next round of fundraising. By only raising as much capital as you need at each round, you can limit the amount of ownership dilution that results from your fundraising efforts.
The big question is: How do you determine how much capital you need at any given time?
Deciding How Much Capital to Raise
Accurately determining how much capital to raise is an important step in avoiding the risk of diluting too much of your ownership. However, it is not a straightforward calculation. To zero in on the right number, start by asking yourself questions like the following:
- What is our monthly burn rate? Your burn rate is the amount of cash it takes to run the operation each month. To determine your current burn rate accurately and forecast it into the future with confidence, you will need to do solid budgeting and financial forecasting grounded in realistic assumptions about your expenses and revenues (if any). It’s especially important to accurately project the most common creeping costs of high-growth companies, like the costs of customer service, customer acquisition and other marketing, equipment, and order fulfillment (if your offering is a tangible product).
- How much money will it take to achieve our next major milestone? When investors consider providing capital to a business, they want to know exactly what their investment is funding. (That’s why you need a well-developed business plan which clearly lays out how you intend to use your funding.) A prudent approach is to seek to raise enough capital to cover the cost of achieving your next major milestone, without having to go out to investors for more money. A milestone is a quantifiable achievement, which is typically tied to product development goals or the level of market adoption or traction you intend to gain at this point.
- How many employees do we need to achieve our next milestone? Since employee salaries and benefits usually represent the largest share of your operating expenses, a simple calculation of the number of employees you need to hire times their average salary can provide a good gauge for how much capital you need to raise during this round.
Once you’ve answered questions like these, you should have a fairly good idea of how much capital you need to raise during your current fundraising round. A good guideline is to raise enough capital to cover your operating costs for the next 12-18 months…at which point, you will be ready for another fundraising round.
Don’t Overlook Your Cap Table
Another common fundraising misstep that can lead to over-dilution of ownership is failing to pay attention to your capitalization table. The cap table lists each type of equity ownership capital, the investors, and their share price. As you add more investors or employees who you grant options to, managing your cap table is critical to ensuring you don’t over dilute your ownership.
A properly developed cap table makes it easier to keep tabs on how equity ownership is changing over time and even model the impact of future equity investments on your percentage of ownership. By adding and adapting financial model valuations and formulas within your cap table, you can look at what-if scenarios before you get too far down the road in negotiations with potential investors. In doing so, you can ensure you don’t inadvertently give away too much equity and dilute your ownership beyond the point that you’re comfortable.
Raising capital is critical to the success of your high-growth company…but striking the right balance between raising the funds you need and avoiding overdiluting your ownership is complicated. Fortunately, the Simple Startup team can help!
We’re the experts that founders and business leaders turn to for help in determining how much capital to raise and how to ensure they maintain the right level of ownership. Our financial modeling, forecasting, and budgeting services are especially helpful in determining exactly how much you should raise at every round. We’re also experts in developing and managing capitalization tables for maximum success.
Book a call with a Simple Startup financial consultant to learn how we can help with financial modeling, forecasting, budgeting, and capitalization table management.