Employee Equity Dilution in Start-up Environment

by
Fred Wilson - Naked Truth
Fred Wilson (Photo credit: Randy Stewart)

Fred Wilson, in his excellent MBA Mondays, talked about Equity as a tool to attract, reward and retain top Executives, Advisers and key people in Start-up environment, and as a compensation of Sweat Equity. 

In the article “Employee Equity: dilution”, he describes one of the most important things to understand about Employee Equity which is likely to be diluted over time.
 
Talent for Equity™ considers this matter as essential and proposes you to share the content with you for explaining those concerns and enlarging points of view.
 
ABSTRACT
 
When a company starts, the co-founders own the whole of the company, and for small business, keep it over time. But in High Growth companies, it is very rare to see founders keep 100% of the business.
 
The typical dilution path for founders and other holders of Employee Equity goes through:
  1. Founders start a company and own 100% of the business in founders stocks.
  2. Founders issue 5-10% of the company to the early employees they hire, generally in restricted stocks or options.
  3. A seed/angel round is done and these early investors acquire 5-20% of the business in return for supplying seed capital.
  4. A Venture round is done and VCs negotiate for 20% of the company and require an Option pool of 10% after the investment be established, and included into the pre-money valuation, meaning the dilution from the option pool is taken before VC investment.
  5. Another Venture round is done with an Option pool refresh to keep the option pool at 10%.
In that example (see Fred Wilson’s blog for calculation details), the founders go from 100% to 42% stake, while early employees’ stake is modified consequently. It is simply to lay out that dilution works for everyone in the cap table.

The earlier you join and invest in the company, the more you will be diluted. Dilution is a fact of life as a shareholder in a start-up. Even after the company becomes profitable and there is no more financing related dilution, you will get diluted by ongoing option pool refresh and M&A activity.

So be prepared for dilution which is a normal part of the Value creation exercise in a startup, and not inherently bad. Fred Wilson’s post helps you to understand it and be comfortable with.
 
For more details, see Fred Wilson’s blog
– Talent for Equity™ team

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