What is dilution?

Cap Table - Part 7

Dilution is a necessary part of startup funding. As a startup adds investors and employees, the founders will start sharing their ownership. The founders will go from 100% ownership to significantly less than 100% ownership. With each funding round and the addition of share option scheme, each investor’s percent ownership will go down, but the valuation (hopefully) should be growing. This is dilution.

As the startup issues more shares with each round and investors assume an increasing portion of ownership, expect dilution to continue. Here is an example of the founder’s ownership changes from the Angel Investors to the Series A investor funding rounds.

After the Angel Investment round, the Founder retains 64.29% ownership.

After the Series A Investment round, the Founder now has 33.90% ownership.

What is a Down Round and how does it impact the Cap Table?

A “down round” is a funding round at a lower valuation than the company’s previous round. Ideally, your startup continues to do well and grows under favorable market conditions. However, the reality is startups sometimes miss milestones, have traction issues, face unfavorable markets, etc. and then need more funds to extend their runway to get through these hard times. When the company is not doing well, it is worth less so the valuation is lower. While down rounds certainly are not fun, they can be necessary for a startup’s survival.

Anti-Dilution Provisions

Anti-dilution provisions are preferred shares rights that give investors (usually venture capitalists) the right to maintain their percent ownership if the next funding round is raised at a lower share price than they paid. In a down round, these investors will not be as diluted when the new shares are issued because the anti-dilution provision gives the investors the right to convert their preferred shares at the new, lower price. There are two types of anti-dilution provisions: full ratchet and weighted average.

We hope you found these seven posts on cap tables helpful. Believe it or not, there is more to learn. What is the impact of full ratchet and weighted average anti-dilution? How do you record crowdfunding investors on the cap table? How do you model investor funding scenarios and potential exit values with your cap table? What is a waterfall calculation?

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