Equity dilution is part of growing a successful startup. The name of the game is striking a balance between funding growth and preserving your ownership stake as a founder. Preventing dilution entirely isn’t realistic or even ideal, but it does pay to minimize it.
If you’re savvy about the timing and terms of fundraising, and you keep the road ahead top of mind, you can reach the best possible outcome.
Use the following 10 tactics to avoid excessive share dilution while growing your startup.
How to Prevent Excessive Equity Dilution in Your Startup
1. Bootstrap your way to early milestones
If you can, focus on growing the business organically before you pursue equity funding. Bootstrapping and growing off your own revenue stream can get you to milestones that validate your business and demonstrate success. This not only gives you more negotiating power in a funding round but also helps increase your startup's valuation to minimize dilution.
2. Explore non-dilutive capital sources
Growth can sometimes be too anemic to show the traction you need to woo investors and raise equity at the terms you want. Explore alternative funding sources beyond venture capital, like debt financing that won’t dilute your equity. Traditional business loans from banks or SBA loans are often the cheapest non-dilutive capital options, but SaaS startups and other recurring revenue businesses don’t usually meet the requirements without hard assets or being profitable. If you’re interested in non-dilutive capital to grow your tech startup, check out revenue-based financing.
3. Use resources efficiently and mind your cash burn
Good business sense and a little fiscal responsibility can go a long way. If you can find engines of growth while keeping your startup lean, you can build the foundation for a sustainable business. Experiment, test, and iterate as you develop your product, and carefully manage your startup’s cash burn and cash flow. That’s a recipe for success that keeps your runway long without a heavy reliance on external capital.
4. Take only as much capital as you need
More isn’t always better. It doesn’t matter whether you’re raising debt or equity capital; don’t take more money than you require. Too much capital is not only difficult to manage and deploy effectively, but it can also cost your business later. If you’re raising equity, less capital means less dilution, and less risk of a down round next time. Before raising capital, map out what you need to do to reach your next milestone, forecast your expenses to get to that stage, and ask for the bare minimum you think you’ll need to execute that plan.
5. Use convertibles wisely
Convertible notes or other convertible securities like SAFEs are types of debt that convert into equity during a future funding round. When these instruments convert, additional shares are issued. What’s the appeal of convertibles? Startups don’t need to make payments right away, and early-stage investors can acquire shares later at a deep discount. Here’s the downside: Discounts and valuation caps protect investors and can significantly dilute founder equity. Dig into the specific inputs of any convertible agreement, and be intentional with your capital structure strategy to minimize impact from these types of securities.
6. Evaluate the risk from warrants
A warrant is an option to purchase a specific number of shares of a company at a set price within an established time frame. When startup investors exercise these options, more shares are issued, which dilutes equity. Warrants present additional risks for startup founders. For example, issuing too many warrants or options can alter the structure of your capitalization table and cause an imbalance of interests between founders, investors, and employees. Investors get upside benefits only from warrants, so ask if this condition is essential to seal the deal in an equity round, and be sure the terms effectively support your company’s long-term growth.
7. Understand everything in the term sheet
Equity funding deals, by design, favor the investor. Investors want to maximize their return if your company is a winning bet, and the levers to ensure that win are spelled out in the deal’s terms and conditions. Make sure you understand the implications and impact of everything in your term sheet, from anti-dilution provisions and pro-rata rights to preferred stock and liquidation preferences. Yes, they are investing money in your business, but you deserve a fair deal that leaves you with some upside if you succeed.
8. Negotiate, negotiate, negotiate
Negotiating a company valuation that sets you up for future success is an important part of raising a priced equity round, but so are the other terms of the deal. Do your best to negotiate terms that are as favorable to you, the founder, as possible. Consider near-term equity dilution, as well as terms that could cause significant dilution later, and make sensible tradeoffs if you believe it’s a deal worth making. For example, your best play might be to negotiate a higher valuation, minimize liquidation preferences, and limit the use of anti-dilution provisions. Strive to preserve as much equity as possible and see where you end up. If you can’t get to terms you like, you don’t have to take that money from that source.
9. Choose investors who offer more than capital
Investors who bring more than money to the table can provide expertise, industry connections, and other valuable resources that give your startup a strategic advantage. The more you’re able to grow and strengthen the business with one round of capital, the more leverage you’ll have in your next funding round to negotiate the most favorable terms and minimize equity dilution.
10. Always plan for the future
Every round of funding sets a precedent for future rounds, so fundraising decisions have to be made in alignment with your long-term strategy and goals. Preserving equity and minimizing dilution is important, but you have to balance that with your opportunities for growth. Prioritize investors you trust who share your business goals, and negotiate terms that give you as much flexibility and control as possible.
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