The Simple Math of Dilution
“Dilution” is a term that often scares founders, but it’s a natural and necessary part of building a successful company. It simply means that your percentage of ownership decreases as new investors put money into the company.
The important thing is not the percentage itself, but the value of that percentage. As your company grows from a small idea to a multi-crore business, your smaller percentage of a much larger pie is worth far more than 100% of a pie that never grew.
Here’s a more detailed example with the numbers:
The Starting Point
- The founders own 100% of the company with 10,000 shares with a face value of ₹10 per share with the paid up share capital of ₹1,00,000.
- Price per share: ₹1,00,000 / 10,000 shares = ₹10 per share.
Seed Round
You raise ₹50 lakhs from an investor.
The investor wants to buy shares at a 10,00,00,000 pre-money valuation.
Post-money valuation = ₹10,00,00,000 (Pre-Money) + ₹50,00,000 (Investment) = ₹ 10,50,00,000
Number of new shares issued to investor: 500 shares
Total shares after investment: 10,000 (old) + 500 (new) = 10,500 shares.
Now let’s see the new ownership percentages:
Founders’ ownership: 10,000 shares / 10,500 total shares = 95.24% of shares
Investor ownership: 500 shares / 10,500 total shares = 4.76% of shares
Founders ownership percentage went down from 100% to 95.24%, but the value of founders stake has increased from ₹1,00,000 to ₹10,00,00,000 (95.24% of ₹10.5 crore post-money valuation) and the price per share has increased from ₹10 to ₹10,000.
The Nuance of SAFEs and Convertible Notes
In India, many early-stage startups use Convertible Notes or SAFEs (Simple Agreement for Future Equity) instead of directly selling equity. These are technically debt instruments that automatically convert into equity at a later funding round. The pre-money vs. post-money calculation gets a little more complex here.
These agreements have two key features that can impact your final valuation:
- Valuation Cap: This sets the maximum valuation at which the investor’s note can convert. If your next funding round valuation is higher than the cap, the investor gets their shares at the capped valuation, not the higher one. This means they get a larger percentage of your company for their initial investment.
- Discount: This allows the investor to convert their note at a discount (e.g., 20%) to the share price of the next funding round.
Why this matters: When you’re negotiating a SAFE, the “valuation” you agree on (the cap) is essentially a pre-money valuation.
However, the actual pre-money valuation for the next round will be determined when the note converts. This can lead to what’s known as “dilution surprise” if you aren’t careful. The investment from all your SAFE holders will be added to the company’s valuation right before the next round, potentially diluting your ownership more than you expected.
Navigating the Conversation with Confidence
Knowing the difference between these two terms gives you a massive advantage. You can speak the investor’s language and show that you understand the mechanics of the deal. Instead of just talking about the product, you can discuss the value you’ve created.
Here are some tips for your next negotiation:
- Know Your Numbers: Before you walk into the room, have a clear sense of your own pre-money valuation and the amount of equity you are willing to part with.
- Do Your Homework: Research recent deals in your industry to get a sense of what similar startups are being valued at.
- Seek Advice: Work with experienced advisors, lawyers, and mentors who have been through this process before. They can help you model different scenarios and protect your interests.
Raising capital is a pivotal step in your journey. While it can seem complex, it’s about finding the right balance between the money you need to grow and the equity you need to keep. By mastering the concepts of pre-money and post-money valuation, you’re not just learning finance terms; you’re preparing to negotiate for the future of your company.
For more in-depth advice on legal documentation, investment, and fundraising, you can visit The Startup Zone’s Investment Advisory Services or contact us directly.
