Dilution
blog.ycombinator.com
blog.ycombinator.com
I honestly think one of the reasons the company I worked for was successful was our inability to raise money while we were young, which forced a real discipline and creativity for how to do more with less. It also made us skeptical of investors and ensured we didn't base our internal feelings about the company based on what a bunch of incredibly fickle investors thought. This was important both when investors hated us, and perhaps more important when they switched and loved us.
And to the second point, I saw first hand how easy money made one of our competitors so cocky they had no chance of success, and another one got too much money and got distracted spending it all to actually make a core business that made sense.
Money is necessary and important, but having too much of it is also a risk that you need to take seriously.
I mean, I do contract work with startups and get paid with investor money all the time, so it's good for me.
But I think most investors are a liability.
First you have to make your employees and your customers happy and now you also have to make investors happy? How shoult this be a good thing?
It's hard enough to build products for users I can't directly interact with, why should this equation get another variable :\
The money makes sense when you need to scale fast. Specially in the development stage, when you don't make a dime yet.
With the advance of the internet marketing, it's don't make much sense, as you put.
Investors should be moving their money from internet, i think, to AI, Space, Augmented reality and so on. They should fund stuff that is really risky. Turns up ... internet is not risky anymore.
This is a myth. I've just parted ways with a second company in a row that had to discover for themselves that 'internet marketing' wouldn't magically solve their top-of-the-funnel problem.
This is not to say that too much money can't cause the problems you mentioned. The cure is to keep the money in the bank and not spend it.
All of the above is what my employer did, not my own personal idea. (Also no VCs, these gut the company if it's neither public nor profitable in 5 years, or at least they used to.)
By experience you don't need years on cash to survive in the long run, discipline and a business that makes sense is way more powerful.
But off course, months of runaway is necessary. More than that is luxury.
You tell them point blank, "we're hoping to make it big this year, but we aren't taking any risks and we're gonna keep enough cash in the bank for the 3 next years. If you don't like this plan, fine, you're missing a chance to buy a stock that's gonna shoot up 10x and here's why", and they buy your pitch, they're gonna beg you to take their money.
I'm not saying I can do this, I'm saying people exist who can, and there are markets where things are measured in years, and so you might want more runway because your progress is way slower than that of a YC-backed Internet monopoly wannabe.
By the way, MIPS Technologies was killed by genius investors who said "give us your $100+ million in cash or invest it" and a genius CEO who said "fine, you ain't gettin' nothin', I'm buying Chip Idea." It turned out that they didn't know how to run Chip Idea and ran it into the ground, and now they had neither money in the bank nor anything to show for it. This drove the company value down so much that Imagination bought it for $60 million (the patents were sold to a big CPU cartel for another $500 million, perhaps unfortunately as genius investors did not get quite the punishment they needed to learn anything.)
A CEO capable of persuading the board of directors to keep the money in the bank would have done better.
that's not a positive pitch. The message sticks, whether you try to negate it or not, if resonating with expectation.
It does. If you must sell your house this week you'll get a lower price than if you can afford to wait for a year for the most eager buyer who's in love with the place. The effect is more pronounced with selling stock in a private company which is much, much harder to price than a house.
> it's still going to happen without cash or a change at the company.
It depends on why you lose money. If you lose money because you acquire many users and lose money on every user, you need to "change" the company in the sense of finding a way to make money on every user, enough to cover your more or less fixed expenses and then some. If you lose money because you're building a product and haven't reached mass production either because it takes a lot of time to ramp up production or because it takes time for demand to show up, say for regulatory reasons, then the "change" is simply getting to mass production. In the latter case, having more money is (in a way) getting you closer to that welcome "change" than in the former.
They had a very good seed round and raised $2M. They used this to develop their first product, which did really well. After 2 years we had 50 employees and were breaking even, sometimes even a bit profitable, so we had even some extra in the bank. Obviously such numbers drove investors crazy, and they went to the highest amount they could raise without selling most of the company. So they raised about $20M.
After a few months our product (and our income) started to dwindle (competitors were upping up their game, different platforms became relevant,...), but the founders were very chill about it - I guess because we had enough cash in the bank to run the business for years without firing anyone. But after a year of so the investors started to panic - no wonder since our revenue numbers were in freefall. After another year or so the founders were forced to sell the company for small change compared to what it was valued at its peak.
Why don't investors offer terms that have steps with growth KPIs (ones you can't spend your way to) that give you more money automatically if you make the metrics? As a company you don't have to constantly raise or bridge but you also can't go drop 5M on new offices. You have all the money and runaway you need as long as you hit the milestones. The investors still have all the same upside but less exposure.
I must be missing something I guess. It would solve issue we have at the startup I'm at now though.
I think it might be a matter of scale: VCs are tiny and they don't have the resources to take such an active role. Even the crazy successful legends like Accel/Sequoia/Benchmark/A16Z/USV/etc employ fewer people than an average company they invest into ~every month.
I don't agree with this advice. Well, in theory, I strongly agree that avoiding excessive dilution is ideal. But the suggested numbers (10% dilution for a seed round) feel very unrealistic to me. It's very hard to get far on that kind of money for a seed stage company. If anything, the proliferation of bridge rounds and seed extensions and series of convertible notes show that even after raising seed rounds, many companies need more capital to get to a series A.
It's also interesting to note that the 10% figure is coming from YC, which takes 7%. That's a considerable amount of dilution, too (and very worth it, IMO).
Finally, I've never been a founder, but I imagine if a company becomes enormous, I'd care less about whether my net worth was $200m or $250m as a founder. So the dilution seems less important than having enough capital for a successful outcome. I'd rather have 60% of a small exit than 80% of a $0 exit.
I do believe in constraints and good cash management, so regardless of how much founders raise, they should be conservative with spend until they have strong product market fit.
Specifically: don't worry about valuation because success is binary. You either make enough money that you don't care too much about percentage or you make zero dollars in which case you don't care about percentage.
The idea of constraints helping to focus a team sounds true, as long as people have enough to not worry about money. Note that this advice comes from Sam, who literally got scurvy from eating too much Ramen while a founder of Loopt.
2) If you can bootstrap to enough revenue, you can try bank loans or things like http://www.saas-capital.com/
3) Unfortunately, the numbers don't work out for VCs if your goal isn't "$1b+ or bust." Almost all companies will exit for much, much less than $1b, but if there's no chance of $1b+ then there's basically no chance that a company will product very meaningful returns for its investors.
From the VC's point of view how is a 5% chance of a $200m exit different from a 1% chance of a $1b exit? (etc.)
Also, if one company is a 5% chance chance at $200m but 0% chance of being worth more than that, while another company is a 1% chance of $1b, the second company might still be a better investment because it's probably 1% chance of $1b AND a 5% chance of $200m if it doesn't go all the way to $1b.
I do agree that there is a market opportunity to fund $50m/year businesses, but that's not what VCs are for.
VCs: Invest in 100 companies, 90 fail, 5 return capital, 3 return 10x, 2 return 100x | 2.35x return on capital over a 10 year period (hopefully)
Index fund: 6% yearly return | 1.79x return on capital over 10 year period
Traditional small business loans average 6-9% APR and have a higher failure rate than an index fund but lower than an index fund. Unfortunately, for startups, they require collateral and/or historical financials.
Most startups either fail or become small businesses. Investors are giving you money to fund a business that you own. Depending on the terms you can, and should, use that money for whatever you want.
Its the investors problem if 5x returns aren't good enough, not yours. Does the bank call you to complain that your mortgage interest rate is too low? No. They gave you the loan with what they thought was reasonable terms at the time. It's not your fault they gave you the money too easily.
You should be focused 100% on building a successful sustainable business. Investors can fuck right off if they push for risks that could turn their 5x return into 0.
If your seed investors are "name brand", and they pass and say, "Ah yes, they're very nice guys. Wonderful conscience, very punctual. Unfortunately I can't follow on, my capital's already allocated. I wish them luck.", you'd better have a plan for profitability.
No, a VC doesn't hate you at the end of the game if they get paid 5x. That's different than answering the question "Will they invest for a promise of a 5x return?"
Binary success ultimately comes from the customer: from their perspective, either the product satisfies their need or it doesn't. As soon as some other product satisfies their need better, they'll switch. And since customers talk to one another and largely like the same things, they tend to do so en-masse, and even $multi-billion giants can find their market evaporates in the span of a couple years.
Of course they're going to tell you not to worry about giving more of the company away, they don't care who owns it. More money flying around is almost invariably a good thing for early investors.
You don't really need advice about funding from anyone, just look at some successful companies and see what they did. Funding is one of the few aspects where you can mimic your startup idols because it's public info.
The fact is, all the biggest unicorns had enough promise and brains behind them to retain majority ownership, or at least full control well into billion dollar territory. If you're good enough investors will be practically begging to give you their money.
Yeah, so fuck the advice from investors. Make sure you keep as much ownership and control over your company as possible until it's sending people to the moon.
Survivorship bias, anyone? You can look backwards at all the success stories. That tells less than 1% of the story, though. What about all the failed companies that did the same thing as the successes? What about all the factors that were irrelevant to success, yet apparent in the success stories?
> The fact is, all the biggest unicorns had enough promise and brains behind them to retain majority ownership
Isn't that pretty close to saying, "All the successful unicorns had apparent qualities of successful unicorns along the way"? How do I become tall? Ensure the top of your head is far away from your feet.
As an ex-founder I never understood why people make this argument because it's completely symmetric. I.e. I could rephrase it as "I imagine if a company becomes enormous, I'd care less whether my outcome was $200m or $250m as a VC"
I agree with the advice in the article but would phrase it slightly differently -- work hard to structure your company such that you can get away with raising as much as you need and still give away only 10%-15% each round. (Or, yet another way to put it, build a company so successful that you can dictate the terms)
If the valuation feels unreasonably high then I'll try to negotiate, or I'll just pass. If the valuation is low and results in too much dilution, then I'll try to figure out with the founder if they can make progress with less money/dilution, or I'll just pass -- because overdiluting sucks for the founder and will also eventually suck for me as an investor by capping the upside.
I think this framing works for the founder, too: if you need $X for your near term plans, and you're getting a fair valuation that doesn't overdilute you, then that's good. If the valuation is unfairly low, try to find other options. If it's unreasonably high, then that's okay if you are good with cash management -- but be mindful that the higher your current valuation, the higher investors' expectations will be for your next round.
Maybe it's different if you're a shit-hot YC company, but man. I thought you were successful if you stayed below 20% at seed.
60% is one funding deal away from becoming a minority stake, while 80% leaves room to do another deal while still maintaining control. Money is not the only concern here.
Maybe I've just been around for too many decades, and seen too many shady deals proposed. But my trust comes slowly -- control issues come first in my mind.
I've known of founders who wouldn't take a deal because they liked being, to use Zuckerberg's honorific, CEO, bitch. And then they rode that into the ground.
I think you're saying they're two forms of the same thing. That's true but they're not two reversible forms. Moreover, there is no control after exit.
So the point is that taking a little less at a concrete exit might be worth more than taking a little more of a sleigh ride.
I agree, this is hard to do. Because most investors triangulate on 15-25% per round, and use the amount of money you expect to raise as a way to back into a valuation.
As a founder, the best way to do this in a seed round would be to raise (all or most of) your seed round from Angels, who are more likely to sign off on a note / safe at a specific cap without knowing the total amount raised, and then you can triangulate on 10%.
It's worth noting that this game is even harder outside of the valley, because while operating costs are significantly lower, so are valuations, and most companies will bump into minimum cash needs for 12-18 months.
Sam made a good point: running out of money is way worse than optimizing for your cap table.
Let me make a second point: Optimizing for success is way more important than optimizing your cap table. In other words: If you believe a specific investor meaningfully adds to the probability of a success state for your company, then its probably a good bet even if you are not happy about the dilution.
In order of what you should care about:
1. Not running out of money.
2. Finding people who can be value-add and help you prevent mistakes and find success.
...
3. Dilution (within reason).
Also, you can always recap founders in later stages. It happens.
If you're asking yourself this question, you're not focusing on building your business. How to spend it becomes a distraction.
The converse also happens: for any business problem the easiest solution is to spend money. Leads? Leadgen firm. Hiring? Recruiters. Code? Outsource, or contract out. Testing? you get the picture.
Throwing money at a problem is a short term fix but fails to build competence at doing that thing. The lack of experience weakens your company in the long term. It's organizational muscle that didn't get exercised. It atrophies over time.
This might make sense for certain areas, but having too much money on hand makes it very tempting to solve all problems with this one hammer.
I feel like seeing concrete examples of how the founders' share of their company changes based on the size/details of a fundraising round would be super useful for founders as they negotiate funding rounds.
Are there any companies currently sharing these details that I'm not aware of?
"I have recently seen several examples of companies doing pretty well and going out to raise B rounds with investors already owning 50-60% of the company. In all cases, they are having a tough time."
I know a company in this position. Not quite going out to raise a Series B, but lots of interest from current Series A investors in doubling down (doing an internal growth round).
What's special about this scenario is that the company is profitable and has millions in revenue and grew 1,200% since the Series A investment round just a couple years ago. But because the pre-Series-A financing was at depressed valuations, there is only 30% of stock for the common, and the founders/employees are (rightfully) worried about dilution. The cap table is clean, but the distribution is unfavorable.
In this case, could founders make a reasonable argument that Series A investors should buy out seed investors and angels rather than diluting the common stock holders further? It seems like secondary liquidity for the angels would be attractive to them, and I heard that when offering secondary liquidity for those seed-stage investors, one could do some sort of "stock-cash swap" that avoids dilution of the common. Anyone heard of something like this or have good reading material about it? It seems like an esoteric "third way" between Series A and exit.
For example in your case why was it bullshit? It sounds like you potentially own less but it got more expensive.
It probably was bullshit because to raise money the company will usually create new shares - and doing this will always make all existing shares own a lesser percentage of the company.
Fun example time! Let's consider a company with 100 shares in total (as printed physical IOUs). An early-stage engineer received 1 of those shares, so they own 1% of the company. Fast forward to the next all-hands meeting, and a founder says they just raised a new investment round. Common practice suggests that the new investors just bought 25% of shares/IOUs. But where did these IOUs come from, if there were only 100 and all are distributed already? In essence, the company just printed new ones, much like the government can print new money. In this case the company started with 100 shares, then printed 33 new ones for the new investors, and now those investors own 33/133 shares or ~25% of the company. And our early-stage engineer owns 1/133 shares, or their ownership got "diluted" to 0.7% from 1%. Perhaps. Or perhaps the company printed 500 new shares, and the new investors now own 80% of the business (500/600 shares), and the engineer owns 0.16% instead of 1%. This is what the engineer is asking: "by how much did I get diluted?". The founder is replying "you didn't", which is mathematically impossible if new shares/IOUs were created. Of course now the engineer's 0.7% is probably worth more in $$$, but that wasn't what they asked.
That's under typical conditions, but it's possible that the founder was correct as long as the company did not print new shares. Two examples come to mind: (1) the founders sold some of their own shares to the new investors at a much higher price, thus keeping the total share count at 100 but implicitly increasing the price of the 1 share the engineer holds. This scenario is unlikely because it's seen as a bad signal - the founders are cashing-in and existing the venture. (2) The company had 100 shares, but only distributed 80 of them initially, so the new investors are getting their shares from the remaining unallocated pool. This means the total share count remains at 100, and the engineer still owns 1% with no dilution, and the price just went up and that's it. Having 10-15% unallocated for attracting talent is normal, but having ~25% unallocated for future fund raising is unnecessary complex and highly unusual.
Well, if that CEO puts up 51% of the capital that might happen. But otherwise the better formula is to be equals as co-founders.
If co-founders are ganging up against each other then that may not be a stable founding team.
Decision paralysis is more a function of not having a clear path forward or having founders without aligned goals than anything else and those are serious problems that need to be dealt with but they do not need to be dealt with on an equity level.
It's much more to do with knowing which role fits you best.
Keep in mind that the CEO functions at the pleasure of the board if you have one and the stockholders if you do not and unless you plan on doing stuff that will go directly against the interest of other shareholders having control is rarely if ever important.
Far more important than the CEO having a controlling percentage of the equity is that the founders have a controlling percentage (and if possible, a supermajority depending on your articles of incorporation and shareholder agreements and whether or not you have more than one class of stock).
If you have a working product and ideally money coming in, the early negotiation leverage changes dramatically. You can skip the seed round entirely, because you've already seeded the project. You can usually get a very good valuation on Series A, since your metrics look great and every VC wants a piece of you. You can negotiate to give away very low equity stakes in later rounds, since at that point you seem like a sure thing.
The flip side is that most side projects don't go anywhere. You need to be both very dedicated and very lucky to strike it big without investment.
When it comes to shares "ownership" does not directly correlate with "control".
1. VCs have portfolios and can talk about averages. As a founder, you're dealing with your particular reality, and as startup phases are inherently high variance... your terms will be all over the map, and not driven by your dilution aspirations. Oh, SaaS crashed this quarter and you lost your F100 account? Too bad for you. Bots are in? Sweet!
2. I'm surprised by the dilution percentages here: I'm guessing they're for the top 10% or so, where everything already aligned anyway. Likewise, I'd expect it for something like a SaaS snack boxes -- stuff where averages and predictability make sense from day 1, not crazy bumpy tech etc. Otherwise, for example, VCs will fight HARD for their % minimums. So, 10-15% sounds like one VC at their absolute bottom... and therefore not normal.
3. 7% might be what accelerators converged on... but that's high compared to F&F, angels, & specialized advisors in your field (vs "startups").
Maybe I over-corrected by choosing to bootstrap, but you can never own too much of your own company.
In the VC's defense, their funds are increasing at a rate disproportionate to the number of partners available to manage the investments.
VCs simply cannot focus on 100 $1M investments with 5 partners.
Don't feel bad, raising money is really fucking hard, stressful, random, and involves a lot of luck.
More literally, for the all VC conversations that got past due diligence, the negotiations simply fizzled out.
Dilution was only one of many factors. It is a very hard and grueling process.
This includes companies with revenue and built product.
The rest of the advice is good and interesting - but it really is for companies that can raise in Silicon Valley.
"...during my career I have raised $100 million..."
Yeah? And how much value did you create?
money to do stuff = good
wise spending = good
these are all known things, i'm not sure this article actually digs much into how to balance them
Because I have none of it.
I definitely have an opiniosn.
I've raised money, couldn't raise money, have had friends that couldn't, have ended up having friends slogging through to become millionaires without any vc, and even turned down rounds hoping to get more.
Now when I look back and think "how would I do this now?" I come to two conclusions.
1. If I want to own an idea as a business owner over the long term, then I don't care about investors. This is my Basecamp spidey sense and convictions. My happy path.
2. My idea is great, I need some money. However.... Nowadays I'm thinking along the lines of "long term (hopefully,, but I suspect that most people don't care bs long term"", which is not SV or wall st friendly. I am seriously looking at non-profit.
Uggggh!
I've been through #1 a gazillion times and now, since I have a family and a diff outlook on life, I'm looking longer term.
But, how does the 'family dude' perspective conflict with the Uber perspective?
Growth is the altar that we all kneel to. The Iron Throne. But, it doesn't have to be this way. Granted, we all have Maslow's needs and that varies based on a number of factors (geographic, personal, etc). But in the end, what is our purpose?
Are we here to sustain sexual harassment via star pupils at Uber so they that their 'CEO' can grow? (At the expense of human beings?)
What is the point of growth or even exponential growth? Money? Riches?
Look, I think YC is better than not and I think that we - we tech people - need to lead the way because we 'can'. Thumbs up on riches, algorithms, and technology. These are awesome progressive things!
But, seriously, after going thru the vc grinder, seeing the cap tables of founders and everyone else and then THEN (stupidly) agreeing to this inequity.. Well, the fault is obviously mine but there is is (a lot) of fault with these pump and dump startups.
Say pre-raise look like this...
- 30% for founders
- 20% for employees
- 50% for future investors
Then when raising initial funds, you sell 20% the total pie (40% of the investor block) of the company to investors, making the share split look like this...
- 30% for founders
- 20% for employees
- 20% for current investors
- 30% for future investors
When an exit occurs, any unallocated shares get split up among the existing shareholders using whatever formula is used to calculate how the money is distributed.
Is it that you want to be able to say to your team members, "you have X% in the worst case" ? I don't think it's practical to make such a statement if you're going down a fundraising path. At best you might be able give a near term worst case, based on the next round or two (e.g. apply the high side of Sam's seed/A dilution ranges). It's all guesswork though, and even with a preallocation you might need to exceed it.
Even if you can't get a different deal you might want to pass. There's just no point. Unless all you want is a salary.
How do these calculations work?
So now you have $10 million in company plus $5 million in cash, so you are worth $15 million (that's called the post-money valuation.) The investor gets $5m / $15m—33% of the company.
Worth of company after adding $5 million from investor: $15 million.
Investor now owns $5 million dollars "worth" of a now $15 million company
$5 / $15 = ~33%
Is this wrong? Investors don't receive anything for their capital but equity. Employees receive income, benefits, etc. that have to be factored into the equation.
Another way to think about it is like this: if an investor told you tomorrow they'd no longer contribute to the company, versus your first engineer, which would be more damaging? The investor's money is already in the bank, whereas the engineer will cost time and money to replace, as well as disrupting the ongoing development.
I think in practice this preference makes more sense when you consider that most of the (non capital based) value that early-stage investors can provide applies mostly to early-stage companies.
If you have a seed company that fails in two years then the equity equation is meaningless. However, if in two years things are going good, but it's not clear you are the next google then you really don't want to lose key employees and it's going to take more equity to keep them interested. On the other hand if in two years it looks like you will be the next google then getting more capital is easy and you really don't want to lose a key person.
The next is always going to be "well, do I have enough money to pay my engineer?" This is why the investor holds all the cards and therefore gets the best deal up front. Without that up-front money there is no eventual business.
You have the option to give that engineer a real slice of the cake instead of the misers share that's common. I've seen co-founders be labeled 'engineer #1' because they sat down 15 minutes after the first meeting where a company's founding was discussed.
Non technical founders can - and do - use investors money to try to limit the number of co-founders so they get a larger share themselves. Technical founders are less likely to do this to non-technical co-founders. (But it does happen.)
Technical people are so great, aren't they! No bias here.
As you said, investors only put in capital (and sometimes advice and/or intros.) Employees work full-time on the company, oftentimes for below-market rates (what they could reasonably assume to make in salary + benefits at larger companies.)
A company at any size is far, far, far more likely to succeed or fail based on its employees than its investors.
Company and work that, in most cases, wouldn't exist without a capital investment.
YC and several other top-tier VCs recommend that you keep the startup as small as possible, oftentimes just the founding team, until you've built a product that's popular enough that you're swamped with demand. Then you can go and raise working capital to fund expansion and fuel growth, but not before. It's not true that the company wouldn't exist without the capital investment, though - it's actually pretty critical that the company does exist before raising capital.
Comparative value.
Most employees are fairly well paid, and don't 'lose years' unless they are working for free, or 'very cheap' which usually isn't the case.
Burnout is a real thing.
The extra bit past 100% is what you get equity for.
Moreover - it's definitely a choice on the part of the employee.
Software developers are generally in high demand, wages are high, and there's no reason to go '150%' unless you feel the 'total package' is right for you.
If service workers were required to put in 70 hours a week for 'no extra comp' then this would be a different story.
If you assume that employees are basically fungible and that $100K in salary will buy the same output regardless of who works for you and how motivated they are, then it makes sense to raise $10M rather than $2M, so you can hire 100 person-years of work rather than 20 person-years. VCs become the limiting factor.
If you assume that there are wide varieties in employee output that stem from a.) hiring the right employees b.) into the right roles and c.) compensating them so that they're incentivized to do their best, then it becomes absolutely critical to attract those employees and motivate them. It is unlikely that you will attract these types of employees for a $100K/year salary. It is far more likely that you will attract them with a percent or two of equity that could be worth several million dollars.
In my experience, the latter is a much closer description of reality than the former is.
From the entrepreneur's perspective, what investors or employees "deserve" is irrelevant, what matters is how much of an effect they have on the ability to deliver a good product to a big market. Early employees are in the trenches with you every day; the difference between high effort and low effort from them can make or break the company. Investors give you money and often advice/introductions, but you are one of many investments in their portfolio; they are not going to give you high effort.
If I were to cut your pay by $100k to join my company, would you say, ah OK but I am still receiving income & benefits, don't worry about it?
If you have to leave your 9-5 to work for my 10-"late" for the same salary, would you want something extra for that, even if it is just a high-EV lotto ticket?
Another argument, made in the article is that if you want to attract the best talent you need to make an attractive offer.
Otherwise why wouldn't the people you want just go work for Google or another startup, or start their own?