Dilution. Or as industry insiders call it, “taking a haircut.”
Everybody knows that when you raise money at a startup your ownership percentage of the company goes down. The goal is to have the value of the startup go up by enough that you own a smaller percentage of a much larger business and therefore your total personal value goes up.
The simplest way to think about this is: If you own 20% of a $2 million company your stake is worth $400,000. If you raise a new round venture capital (say $2.5 million at a $7.5 million pre-money valuation, which is a $10 million post-money) you get diluted by 25% (2.5m / 10m). So you own 15% of the new company but that 15% is now worth $1.5 million or a gain of $1.1 million.
But understanding how you’re likely to get diluted over time is a more difficult concept. And figuring out how much your equity may be worth over the course of a 5-year stint at a startup is even more complicated.
I’ve had to simplify a bit, but to make it easier to understand I’ve teamed up with Jess Bachman at Visual.ly. If you want to see a view of the power of their work check out this Steve Jobs infographic. I’m a huge believer in Info Graphics and the ability to create deeper understanding of complicated topics through visual means. As “Big Data” becomes more pervasive the power to visualize will become increasingly important.
And Jess is awesome at his trade. His personal blog with some great example is here.
So here is our crack at explaining the world of dilution to you. Let us know what you think. And if you want more goodness like this don’t forget to sign up to my newsletter and follow Jess on Twitter. We’ll bring you some more goodness again. Let us know what topics you want us to break down for ya.
Listen, understanding the world of valuations and how equity gets split on a sale is a whole lot more complicated than the graphic depicts. I hope it gave you a flavor. If you want a deeper dive I shot some video on calculating ownership and dilution over time. And make sure to read VentureHacks.
(Cross-posted @ Both Sides of the Table)