Over the past few weeks, I’ve been fortunate enough to catch up with several Unicorn++ founders who, relatively speaking, had not raised that much vs their peers. We talked about a lot of things from scaling, to IPOs, to the journey, and more.
But one thing all 3 brought up that surprised me was Dilution. They talked a lot about dilution. From a longer-termer’s perspective. This is from folks worth so much on an absolute scale it’s hard to imagine perhaps why Dilution would be top of mind. Especially since they hadn’t relatively speaking even raised that much. But it’s because only after 7, 10, 15, 20 years into the founder journey that you truly see how dilution plays out.
I thought a lot about these discussions. For many folks, dilution from an equity fundraise is a luxury. The vast majority of startups struggle to raise even a tiny bit of angel funding, let alone a single round of venture funding.
But once you do take off, venture capital will likely at least be an option. And it can be the greatest gift to accelerating your business there is. Extra money to hire those 2-3 great VPs. To build that world-class salesteam faster. To dominate your market. Do it. Go for it. The Cloud is far bigger than ever. And with that, the opportunities.
You will likely look back though and somewhat regret the dilution you didn’t need to take, though.
The first dilution you will come to lament is Departed Founder Dilution. I’ve never met a founder who had a co-founder quit in the first 24 months who felt the post-split equity split was fair. So to mitigate the unintended impacts here, I strongly recommend using the Founder Commitment Test. It won’t eliminate these issues, but it will at least align you on them. More here:
The next dilution you hopefully won’t lament, but may, is shares you give away before any material equity financing. There are a lot of scams and rip-offs in the pre-seed stage, and we’ll have to hold those for another post. My simple tip here though is whatever you do, think twice about a third-tier accelerator that wants a lot of equity. I’ve never seen a successful founder that gave 5%-7% to a third-tier accelerator that said it was worth it down the road. Also be careful about anyone asking for material equity not committing to really doing significant work. These you’ll all regret. Also, have fewer, better advisors.
On VC financing, here are my 3 suggestions (and 1 framework) on how to think about Dilution:
- First, raise 125% of what you need in VC capital in each round. I’m not the first to write this, but boy is it ever true. I needed 125% of what I raised every time I raised myself, and I’ve seen this in almost every one of the 24+ SaaS start-ups I’ve invested in or advised. Founders almost always think the cash will last longer than it does. And even if you model cash correctly, you almost always end up wanting to make that extra hire or two to get to the next level. Raising 125% of what you think you need gives you the buffer to do it. Generally speaking, if you can raise say $1m or $2m in VC capital, the investors will be happy to invest 125% of that. Especially in 2019. Of course, a bit more dilution will accompany that.
- Second, raise if the price is insane. If you are hot and you can get an incredible price (i.e., >=3x more than you are worth), just take it … if you will need it later. Yes, it will put more pressure on you. But you will save so much dilution if you don’t also increase your burn rate. So add discipline in burn to a crazy price, and you have a solution to ultimately skip half a funding (and dilution) round in VC financing. More on skipping a round below.
- Raise if it helps you dominate. Some categories of software lend themselves to market dominance through some level of brute force. Through $10m+ of partner marketing, 500 sales reps, etc. etc. You’ll know, at least by $5m-$6m in ARR, if this will work for you. If it can, do it. Especially if it can get you to 70%+ market share. Yes, the dilution will be intense. But if you don’t do it, they will. Only one vendor can get to 70% market share, after all.
- But Otherwise — Hold. If you don’t need it, if the price isn’t insane, AND the money won’t help you dominate, don’t raise. Don’t be attracted to the TechCrunch headlines. This is the dilution you’ll regret.
In the end, if you go down the venture path, there will be 2 dilution paths that make you “happy” — either skipping a round (more on that here) via Holding one hand; or Dominating. If you use VC capital to truly dominate, the dilution is almost always worth it. But the middle paths are fraught with frustration down the road.
After VC financing, then if you are going long, you’ll find employee dilution becomes a huge challenge down the road. You won’t understand this in the early days. You’ll put aside 15%-20% for the option pool, and it will seem like that will last forever. But once you are on your third management team, past 200+ employees, etc. … then every share will count. You will scrambling to find enough for employee #600, for VP #10. Down the road, you’ll likely suffer an additional 5%-7% dilution every year from hiring. This is why Big Tech Companies are always buying back so many shares each year. It offsets this dilution. Especially the dilution to management.
In the end, Dilution is Like Inflation. Both are just a fact of life. Both don’t exist in the short term. But both compound over time into something material. So don’t make short-term decisions around it. But plan as best you can. Take 125% of what you need. Get founder vesting right. And choose the path that works for your segment, your competitive space, and your values.