Employee Equity: Dilution

Posted on by Fred Wilson & Jason Li

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Last week I kicked off my MBA Mondays series on Employee Equity. Today I am going to talk about one of the most important things you need to understand about employee equity; it is likely to be diluted over time.

When you start a company, you and your founders own 100% of the company. That is usually in the form of founders stock. If you never raise any outside capital and you never give any stock away to employees or others, then you can keep all of that equity for yourself. It happens a lot in small businesses. But in high growth tech companies like the kind I work with, it is very rare to see the founders keep 100% of the business.

The typical dilution path for founders and other holders of employee equity goes like this:

1) Founders start company and own 100% of the business in founders stock

2) Founders issue 5-10% of the company to the early employees they hire. This can be done in options but is often done in the form of restricted stock. Sometimes they even use “founders stock” for these hires. Let’s use 7.5% for our rolling dilution calculation. At this point the founders own 92.5% of the company and the employees own 7.5%.

3) A seed/angel round is done. These early investors acquire 5-20% of the business in return for supplying seed capital. Let’ use 10% for our rolling dilution calcuation. Now the founders own 83.25% of the company (92.5% times 90%), the employees own 6.75% (7.5% times 90%), and the investors own 10%.

4) A venture round is done. The VCs negotiate for 20% of the company and require an option pool of 10% after the investment be established and put into the “pre money valuation”. That means the dilution from the option pool is taken before the VC investment. There are two diluting events going on here. Let’s walk through them both.

When the 10% option pool is set up, everyone is diluted 12.5% because the option pool has to be 10% after the investment so it is 12.5% before the investment. So the founders now own 72.8% (83.25% times 87.5%), the seed investors own 8.75% (10% times 87.5%), and the employees now own 18.4% (6.8% times 87.5% plus 12.5%).

When the VC investment closes, everyone is diluted 20%. So the founders now own 58.3% (72.8% times 80%), the seed investors own 7% (8.75% times 80%), the VCs own 20%, and the employees own 14.7% (18.4% times 80%). Of that 14.7%, the new pool represents 10%.

5) Another venture round is done with an option pool refresh to keep the option pool at 10%. See the spreadsheet below to see how the dilution works in this round (and all previous rounds). By the time that the second VC round is done, the founders have been diluted from 100% to 42.1%, the early employees have been diluted from 7.5% to 3.4%, and the seed investors have been diluted from 10% to 5.1%.

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I’ve uploaded this spreadsheet to google docs so all of you can look at it and play with it. If anyone finds any errors in it, please let me know and I’ll fix them.

This rolling dilution calculation is just an example. If you have diluted more than that, don’t get upset. Most founders end up with less than 42% after rounds of financing and employee grants. The point of this exercise is not to lock down onto some magic formula. Every company will be different. It is simply to lay out how dilution works for everyone in the cap table.

Here is the bottom line. If you are the first shareholder, you will take the most dilution. 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 startup. Even after the company becomes profitable and there is no more financing related dilution, you will get diluted by ongoing option pool refreshes and M&A activity.

When you are issued employee equity, be prepared for dilution. It is not a bad thing. It is a normal part of the value creation exercise that a startup is. But you need to understand it and be comfortable with it. I hope this post has helped with that.

 

From the comments

Dan Lewis started a lively exchange with:

Early employees seem to take a huge hit here. Let’s say you hire three people early on at the 7.5% total you posit. With dilution, etc., that’s 1% of the company by the time your shares vest four years out. And those four years come with reduced salaries and a ton of risk — if you work for, say, Wesabe for four years as a non-founding early employee, there’s no exit, no reputational gain outside of the entrepreneurial world, and potentially a reputational hit within it. That’s a bad thing, and I wonder if the upside is enough to make it acceptable.

So let’s look at a good outcomes:
* Mint’s sale to Intuit for $170MM. Ignore the further dilution from the C-round, and they walk away with $1.7MM.
* Associated Content to Yahoo, $90MM. Again, a C-round. $900k each.

And neither of these take into consideration the liquidation preference of investors. It seems like there should be horror stories of early employees of startups which had tiny exits, but honestly, I don’t recall seeing any. Why’s that?

To which Harry DeMott replied with:

You don’t see the stories because the alternative is working as a coder for HP or Dell for 4 years at $120K per year in salary and some benefits. End of 4 years you have taken home just under $500K – and you keep $350K of that after tax.

Most of these exits – even if they are small – are better than the alternative.

And in the meantime – people feel they are much more part of a team – they are doing meaningful work (to them) – hopefully in an area they love – and have much more chance of moving up in food chain the next time around.

None of this is really available in a colossus – there, it is just a job.

Dan Lewis replied in turn:

Yeah, but why not instead start a hobby which could have similar
marginal upside but allow you to keep your job?

The potential grand slam exit for an early startup employee is
typically overstated dramatically.

Greg Neichin added:

Spot on Dan… completely agree that the math for early employees is often entirely uninspiring. I think that 1% ownership is fair for employees 1-4, but employee 5-10 are looking at even less. I spent nearly four years on the management team of a successful venture-backed startup (came in around employee #10). We sold the business (doing ~$20M in revenue) to another private company that subsequently went public (Convio). The outcome for me sounds great on my resume and I wouldn’t trade the experience for anything, but it will net me a bit more than enough to pay off my graduate school loads. Certainly not a life changing monetary experience.

Then JLM weighed in:

“Certainly not a life changing monetary experience.”

Your life is not yet over (well I hope so). And it will turn out to be a life changing experience on many levels not just monetary. You made it to the pay window and you have drunk deeply from the elixir of life.

One of the very best things that ever happened to me was getting screwed out of a $2MM payday. Not a subtle, delicate, complex matter — an old fashioned “I’m not going to pay you, go sue me” kind of matter. A real disillusionment and a great lesson.

Best thing that every happened to me.

I took a 4 month European vacation, got in the best physical shape of my life, fell more deeply in love with my wife and life, came home — tanned, rested and ready — and went into business for myself.

You are now locked and loaded — poised — for great things. On the strength of your description and your avatar alone, I would buy stock in you right now, sight unseen.

Go bite the ass off a bear. Figuratively speaking, mind you.

fredwilson wrote back to JLM with:

Of course he did

Those who make money by taking from others don’t make good business people

Those who make money by generating wealth for everyone are heroes

 

This article was originally written by Fred Wilson on October 4, 2010 here.