Discover what dilution is and how it can affect your startup’s development

Promoting the development of one or more products, scaling up the company more quickly or expanding into new markets are some of the reasons given for a startup to require a capital increase. But getting that backing has a relevant effect: share dilution, a phenomenon that causes the ownership of the company’s founders and partners to be reduced.

An approach to share dilution in startups

If we imagine a startup as if it were a cake, the entry of new capital in each financing round makes its size increase so that old partners or new investors can take a slice of it.

When this happens, two scenarios open up for both the entrepreneur and those who already have a stake in the business. On the one hand, they can either go to the financing round so that their percentage does not decrease (i.e., have a proportionally larger piece of the cake) or abstain and assume that their slice will be smaller (as the size of the cake increases).

The latter does not mean that its shares have a lower valuation. Even if they keep the same number of shares, these may increase or decrease in price. Simply put, they will have a smaller percentage of the total with the capital increase and give up part of their ownership. But how can it be calculated? What aspects should be taken into account?

How to calculate dilution in a financing round

Before the capital increase takes place, it is possible to calculate the percentage to be acquired by the new investor and the number of shares to be issued. According to Upbizor, a consulting firm specialising in the entrepreneurial ecosystem, several concepts come into play in these calculations:

• Number of shares, with their nominal value.
• Pre-money valuation (i.e., valuation of the startup before the entry of new capital) and post-money valuation (valuation of the company after adding the pre-money valuation and the new capital inflow).
• Contribution in the capital increase.

To calculate what percentage the new partner will have, it is only necessary to divide the contributed capital and the post-money valuation. In a practical example,

• Pre-money valuation: € 1,000,000
• Capital contribution: € 200,000
• Post-money valuation: € 1,200,000. This is the result of the sum of the pre-money valuation and the capital contribution.
• Percentage of capital of new investors: 16.66%.
• Percentage of equity of former investors (founding partners and former investors): 83.3% (compared to 100% before the investment round).

But how many shares must be issued to acquire that percentage? To speed up this process, specialised platforms such as Capboard.io are available to founders and partners. In this equation, we must take into account:

• The number of shares prior to the investment round, e.g., 30,000.
• The capital of the investment round: 200,000 euros.
• The target percentage: 16.66 %.

Therefore, it will be necessary to issue 5,714 shares.

Precautions to avoid dilution

Dilution should be taken as a natural effect in the evolution of any startup. However, both entrepreneurs and early investors must monitor this process to drive the project forward without losing control of the company.

The Brazilian investment fund Latitud recommends that founders retain 50 or 60% of the company’s ownership when closing a Series A financing round. In addition, it is also advisable for dilution to be between 15 and 20% per round.

To limit dilution, founders and early investors can take a few steps:

• Think ahead. To avoid a high dilution of shares, the founders must have their sights set on the medium term and set good precedents so that in later phases they can establish conditions similar to those agreed in previous financing rounds.
• Resort to financing alternatives that totally or partially avoid dilution. Solutions such as venture debt, consisting of debt that is repaid with interest and a small portion that is used to acquire shares in the company, or growth loans, loans for which ownership is not transferred, allow the shareholding to remain largely unaffected.

Partners such as BBVA Spark offer these types of solutions that allow entrepreneurs to obtain capital to develop their business plans.

What are anti-dilution rights?

In complex contexts, attracting investment becomes a challenge for high-growth companies, which may suffer variations in their valuation. If it declines, after a new round of investment, the investor would have paid a price higher than the value of the company.

To protect themselves in this type of situation, founders and investors often introduce anti-dilution clauses, a mechanism designed to protect the value of the investment if shares are issued in future rounds at a lower price than previously paid.

In such a case, the investor could exercise its right to issue new shares to offset the loss of value or restructure the capital to adapt it to what it should have received at the beginning. Therefore, in order not to include this clause, the Delvy law firm recommends that entrepreneurs “negotiate and agree with investors on the valuation of financing rounds.”

Growth is the verb that guides startups in their development. However, it is important to ensure that this does not happen at any price so that, if the founders so wish, the cake always retains the ingredients that launched it to success: their ideas and vision, as well as the commitment of the investors who backed the project in the beginning. However, sometimes, for those entrepreneurs who aspire to achieve profits with the sale of the company (‘exit’) it is also relevant to monitor this section if, at the end of the day, they want to obtain the maximum profit.