Note: The new pool is usually diluted proportionately by the older shareholders and the new investor ratio is based on post-investment valuations.
In-depth understanding of the dilution of equity: mandatory course on entrepreneurs ' financing
Dilution of equity is an inevitable process in the growth of start-up firms. It means that the percentage of equity held by the original shareholders decreases when the company introduces new funds or adds a pool of options. But this is usually seen as a “big-up” process — although the percentage held has become smaller, its corresponding asset value (valuation) is usually significantly higher.
Core concept: pre- and post-investment valuation
The first step in understanding dilution is to distinguish between two basic terms:
- Pre-fund valuation (Pre-Money valuation): The value agreed upon by the company before the infusion of the funds.
- Post-Money valuation: Pre-investment valuation + financing amount.
- Share of investors: Amount of financing = valuation after impact. For example, 8 million ahead of the investment and 2 million finance, 10 million after the investment, and 20 per cent of investors.
Why is there a “reduration”?
In addition to the dilution brought by investors, the new round of finance is often accompanied by an expansion of the **ESP Pool**. Investors usually require that a certain percentage of the company ' s equity (e.g. 10-15 per cent) be set aside before or when they enter the stock, to motivate the core team of the future. If this option is added at the time of financing, it further dilutes the share of the original shareholders.
How can one protect one's own self through calculations?
As founder, when obtaining Term Sheet (intentional investment), the focus should be on measuring:
- Control after dilution: Can one vote be maintained on the Board of Directors or on major matters?
- Anti-dilution clause: How the original equity is protected in a possible future “down-down financing” (Down Round).
- Book value added: Although holding shares fell from 80% to 60%, if the company's valuation rose from 10 million to 100 million, your wealth actually grew 7.5 times.
4. Importance of Cap Table (share structure table)
A clear Cap Table is not only for investors, but also a key tool for the founders to understand in real time the distribution of corporate interests, voting rights and exit value maps. It is recommended that multiple scenarios (Scenarios) be simulated repeatedly using the calculator before the details of each round of financing are finalized.