April 1, 2022

Founder equity dilution: is giving up ownership the right financial move?

Raising VC may seem tempting. But down the road, you risk diluting the ownership of your startup. Managing equity is a tightrope walk. Here are some thoughts we have on the topic.


As your business evolves, it’s inevitable that you’ll run into challenges around cash flow. Especially during expansion phases, you may be wondering whether it makes sense to raise venture capital (VC) or explore other options. Raising VC may seem tempting. But down the road, you risk diluting the ownership of your startup.

Managing equity is a tightrope walk. Here are some thoughts that our team at Capchase has on the topic.

A balanced approach to VC

VC comes with a lot of upside, but there are risks that come with being too aggressive about fundraising.

Envision what your company could be like in 10 years, given the right market conditions. Maybe a liquidity event such as an IPO, merger, or acquisition is on the horizon.

After years of hard work, it’s important that as a founder, you receive the outcome and financial compensation that matches your level of contribution. That means protecting your equity.

As startups evolve, it takes an increasing amount of resources and mentorship to bring big visions to life. Depending on your business model and growth goals, the VC path may be inevitable. 

When thinking about your fundraising strategy, it’s important to cover your bases. Often, that means learning from the experiences — both successes and failures — of fellow founders.

Recently, Inc Magazine contributor Carey Smith interviewed 40 founders who lost controlling interest in their companies, with half owning 20 percent or less.  In his research, he met a founder who had raised $100M over two rounds to build a $65M manufacturing operation. This founder encountered challenges due to not having a financial management strategy. The entrepreneur continued to fundraise until he was down to less than 20 percent ownership. With such little equity remaining (and no self-sustaining sales), it became a challenge to persuade new investors.

When giving up equity is the right path 

When giving up equity, the tradeoff needs to be worth it.

Working with VCs has the potential to be a positive strategic move.

As a founder, you can protect your equity by knowing the ins and outs of dilution. This early-on awareness can help you prevent problems down the road. Here are some resources to help you self-educate on the topic:

1. Balancing the Art of Valuation with the Science of Dilution (Techstars)

This article focuses on strategies that founders can use to help maximize the valuation of their businesses and increase the propensity for new investors to enter the equation. One takeaway is that some dilution is inevitable, but founders can take steps to protect their ownership.

2. Dilution: The Good, the Bad, and the Ugly (TechCrunch)

There’s good dilution and bad dilution, according to TechCrunch writer Bernard Moon. The key challenge is that it’s hard for founders to predict what future funding rounds will look like for their businesses. Managing dilution can be tricky, as ownership percentage is not the only measure for good decision-making. The quality of the investor matters too. The bottom line is that fundraising is about tradeoffs. This article explores the topic in greater depth.

3. How to Manage Equity Dilution as an Early Stage Startup (Carta)

Beneath the surface, legal constructs for equity dilution can get complex. This article walks through different techniques for founders to hold onto their ownership. When founders  begin to realize the impact of dilution, it becomes too late to take action. This article recommends creating a model for the impact of dilution, first.

4. The Pros and Cons of Giving Up Equity (Bigfoot Capital)

There are clear benefits for founders holding on to ownership of their companies:

  • Retaining more control and optionality
  • Retaining long-term upside as you continue building equity value
  • Preserving equity that you can sell (or dole out to your valued current and future employees), when you’re further down the road, can command a higher valuation, and therefore, require you to take less dilution

But these benefits aren’t always worth it. That’s because VCs open doors for network expansion and operating expertise. The best VCs have deeply-developed networks in their focus areas. These connections are assets that will grow the value of the company in which they have equity.

5. The Founder’s Dilemma (Harvard Business Review)

In the early 2000s, around the time that technology began advancing, Harvard Business School professor Noam Wasserman was interested in studying the criteria for startup success. One topic he examined was the relationship between founder equity dilution and company performance. His research has found that when founders give up more equity to attract co-founders, talent, and investors, the end result is a more valuable company than a comparable one with less equity.

Other funding options 

Founders have options beyond VC to manage their capital. For one, there’s credit.

In addition to traditional options such as credit cards and lines of credit from banks, there are a number of private lenders entering the market. This economic movement is known as “alternative lending.” It’s an emerging market in the finance industry due to the evolution and acceleration of technology. With the rise of digital banking, there are a range of options in the market:

  • Invoice financing or factoring
  • Crowdfunding
  • Peer to peer (P2P) lending
  • Lines of credit
  • Term loans
  • Merchant cash advances
  • Revenue based financing

As an example, Capchase is an alternative financing partner that specializes in revenue-based financing. With this type of financing, businesses can apply to upfront their capital against monthly recurring revenue (MRR). We use intelligent software to determine monthly payback rates and terms for our customers that are fair, flexible, and transparent.

Through credit, founders can access working capital funds without needing to give up equity. The idea is to have flexible access to working capital, without needing to take on venture capital.

 

Are you interested in learning more about revenue financing?

It’s important to do your research and make the decision that’s best for your business. Here are 3 immediate steps you can take: 

 

Before making any decisions, it is a good idea to consult with a financial advisor.

Disclosure

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal, or tax advice.