How do you factor in dilution when negotiating financing terms?

In my experience before fund raising and dilution, one must understand the “Fair Market Value” of a business venture or a startup. The pre and post money valuations are a function of the Fair Market Value. Assessing the valuation inaccurately can prove costly for the Founders in the long-run. At the same time overvaluing a business venture will create issues in financing for the future rounds and fund raising.

This is a 101 of fundraising but it's just jargon and the math is simple so founders, don't be stumped by it. Pre-money is the valuation before the invested capital in injected into the company. Post-money valuation is the pre-money valuation plus whatever amount that was going to be invested. Simply put Pre-money = $100 Investment = $25 Post-money = $100 + $25 = $125 The information the founders will be looking out for is the dilution that founders and other shareholders will be impacted by. In the example above, the new investor now owns 20% of the company, calculated as $25 of $125. And thus existing shareholders are diluted by 20%. Hope that helps and drop me a connect??

Pre-money valuation refers to the value of the company before new financing is added, while post-money valuation includes the value of the company immediately after receiving the financing. These valuations are critical in determining how much equity new investors receive and the resulting dilution of existing shares. Understanding the difference helps founders and existing investors grasp the impact of the new financing round on their ownership percentages.

It could be considered and negotiated at each stage of investment as well as considering how many times the company has already diluted. It is also important to see what the level of the founders interest in the company is.

Pre-money and post-money valuation: Pre-money is the valuation before the investment. Post-money is after, incorporating both the valuation and the new money.

To calculate your new ownership percentage post-dilution, divide the value of your investment by the post-money valuation of the company. For example, if you own shares worth $1 million in a company with a post-money valuation of $10 million, your ownership stake is 10%. If a new financing round introduces more shares without increasing your share count, your percentage of the total will decrease, reflecting dilution.

Calculating ownership stake: Use the pre and post valuations to calculate your percentage ownership before and after the financing. Ownership will get diluted down.

Calculating ownership stake after dilution is like figuring out your slice of the pie after more guests arrive. Divide your investment by the post-money valuation to find your initial stake. Then, account for any additional shares issued during the financing round to determine your diluted ownership. This ensures you have a clear picture of your stake in the company moving forward.

You can evaluate the ownership stake after dilution to manage portfolio. For example, if ownership stake decreases significantly due to dilution, you may want to evaluate the risk-return profile of the investment and strategies to mitigate the impact, such as participating in follow-on funding rounds to maintain ownership percentage. You can enhance the overall performance of portfolio and deliver strong returns for your investors by evaluating dilution

Common dilution scenarios include new financing rounds, the issuance of stock options to employees (option pool dilution), and convertible notes converting into equity. Each of these scenarios increases the total number of shares, diluting the ownership percentage of existing shareholders unless they participate pro-rata in the new investments.

Common dilution scenarios: Later funding rounds at higher valuations Issuing new shares to employees or advisors

Dilution can come in various forms, like issuing new shares to investors, employees exercising stock options, or convertible securities converting into equity. Each scenario affects existing shareholders differently, impacting ownership percentages and control. Being aware of these potential dilution events helps you anticipate their effects and plan accordingly.

Anti-dilution clauses protect investors from dilution in future financing rounds by adjusting their share price or the number of shares they hold. The most common types are full ratchet and weighted average. Full ratchet anti-dilution adjusts the price of the existing investors' shares to match the price of the new shares in a down round, while weighted average anti-dilution provides a less drastic adjustment based on the number of new shares issued and the prices involved.

Anti-dilution clauses: These protect investors against dilution in down rounds. Full ratchet and broad-based weighted average are two common types.

Anti-dilution clauses act as a safety net for investors, protecting their ownership stakes in case of future financing at a lower valuation. These clauses come in different forms—like full ratchet or weighted average—and provide mechanisms to adjust the investor’s ownership to maintain their original economic interest. Negotiating for appropriate anti-dilution protection safeguards your investment against potential downside risks.

Negotiating financing terms to minimize dilution involves several strategies. Founders can seek higher valuations to reduce the equity percentage given away in each round, limit the size of the option pool, or negotiate for pro-rata rights that allow them to maintain their ownership percentage by participating in future rounds. Establishing clear terms around anti-dilution protections is also key.

Model multi-round dilution scenarios Weigh dilution vs growth capital needs Get advice from experienced lawyers and advisors

Negotiation is all about understanding between the two parties.Strive for understanding as to why VC or entrepreneur is in that negotiation.The underlying motivation between the two parties will help in financing negotiations

(a) Tranche investments, contingent upon meeting predefined milestones, can be a strategic way to manage dilution by linking capital infusion to performance & valuation increments. This was applied in a Series A round for an AI startup, where funding was released in tranches as specific technological development & market penetration milestones were achieved, aligning dilution with value creation (b) Liquidation preferences impact dilution & the distribution of proceeds in exit scenarios. Negotiating fair liquidation terms ensures that dilution does not disproportionately disadvantage any party. In a venture I was part of, we structured liquidation preferences to be non-participating, which prevented disproportionate dilution of the founders

Factor in the company’s growth trajectory, market potential, and fundraising roadmap when negotiating financing terms. Strive for a balance between short-term dilution concerns and long-term value creation. Building trust and transparency in negotiations fosters stronger partnerships, setting the stage for mutual success in the journey ahead.

How to minimize dilution: Negotiate valuation carefully each round Limit new share issuances between rounds Understand implications of full ratchet provisions