If you have viewed the Oscar Best Picture nominated film, The Social Network, you may remember the powerful scene when Facebook founder, Mark Zuckerberg’s friend, Eduardo learned he was practically ‘diluted’ out of any substantial ownership of the new company. This was after a number of rounds of venture capital start up financing. The scene is powerful because Eduardo knew that with every stage of new investment, the founders’ equity in the company got smaller and smaller. Ultimately, his ownership share was diluted to less than 1%.
What is dilution and how can you avoid getting ‘diluted’ out of your proper share of a start-up company? Consider a cup of water with a few drops of food coloring. You can easily see the coloring in the water. However, after adding three more gallons of water, the color of the water is diluted so much that you can hardly discern it at all.
The same thing happens when more and more money is invested in a start-up company. The more a venture capital invests start up financing in a business, the more equity they will claim in the company and dilute the founders to a less substantial position.
What can you do to assure that you and your co-founders of a start-up company are not completely diluted? Here are a few tips.
Ask How Much Dilution is Likely to Occur
When working with venture capital firm for your start up financing, be completely upfront and ask how much dilution may occur. This is especially important if you expect at least three rounds of start up financing.
The more successful your start up company is, and the more value it gains with each stage of start up financing, the better off you’ll be. However, do realize that if your business value remains about the same or even decreases, your amount of dilution will increase at a dramatic rate.
Obtain a Dilution Schedule
It is perfectly within your right to obtain a dilution schedule. A dilution schedule is simply a matrix listing each current ownership interest, including yours, your co-founders, mangers, and the venture capital group(s).
The matrix should also list all the series of start up financing A, B, C, etc, plus any convertible notes, warrants, common stock, and any convertible preferred stock. The total amount of equity interest for each party should add up to 100%. Double check the math and be sure to discuss any dilution that seems out of the ordinary.
Your start up business may not grow at the rate that Facebook did when it first hit the market. However, even so, you need to protect your equity interest and avoid over dilution.