Understanding Dilution of Ownership

There is a lot of confusion surrounding the dilution of ownership, especially in the tech startup space. What does this mean in layman’s terms? Who does it impact? And most importantly, why you should care if you plan to work for a startup. This is a topic I have discussed with many new (and even some seasoned) engineers over the past few years. I recently had this very discussion with a senior engineer (and close friend) who is leaving big enterprise for startup land. He suggested I write a blog in the plain speak that I used with him. Little does he know (until now) that this is as deep as I go on this topic!

A Few Thoughts on Funding

Building a startup isn’t easy and neither is scaling it. Founders are on the hook for securing capital and balancing the tricky scale of timing, valuation, and dilution of ownership. Venture Capital, especially in tech, plays a huge role in fueling innovation and accelerating growth. Why is this? While there are probably many answers to this, I think the primary reason is a result of how fast technology changes. This rapid change and additional contenders getting introduced in a particular market accelerate things and create additional competitive pressures.

Taylor Builds a Great Tech Startup

Let’s dream up a hypothetical scenario! Meet Taylor, a world-class engineer turned entrepreneur. Taylor cooks up a fantastic idea for a platform that uses AI to verify the authenticity and originality of music, allowing one to distinguish human-created music from AI-generated content. Taylor puts together a top-notch founding team with some ex-engineers and has connections in the VC space to strike while the iron is hot. At the time of founding, the initial ownership is divided amongst Taylor, the founding team, and any investors. Let’s say there are 100,000 shares in total, and Taylor owns 40,000 shares. This means Taylor has 40% ownership.

The Dilution Effect

Taylor’s startup is established, the market fit is great, and operations are in place: it’s growth time! This means hiring sales, engineering, or other talent to scale the business. Taylor decides to raise an additional round of funding to make this happen. Additional shares get issued that the investors can then purchase. Let’s say, for the sake of example, Taylor’s startup issues an additional 50K shares in a Series: B round, bringing the total number of shares to 150,000. The dilution effect is apparent: Taylor retains the same amount of shares (40,000), but her ownership is now 26% as a percentage of the new total.

Who gets Impacted?

Dilution can impact the founders who built the company, the investors who supplied funding, and any employees holding stock options or equity. A fundraising round can take the form of a down-round (valuation decreases vs. previous round), at par, or up-round (valuation increases vs. previous round). The outcome here largely determines how each class of shareholder is impacted moving forward.

• Investors: As more shares get issued, the percentage of ownership that early investors hold in the company decreases, which may impact decision-making power and influence based on round dynamics.
• Founders: With founders, although the company’s value may increase, their slice of the pie continues to shrink. This can potentially minimize the control and influence a founder has on the direction of the company, but if they are strategically essential to the business, the ownership percentage is just one dimension of influence.
• Employees: Like our other two groups, the share of ownership for employees is diminished, thus potentially impacting employee morale. If the value of the shares don’t meet expected growth for employees, it may be addressed through increase salaries and additional shares. In advanced private stage companies, strong performers also typically get annual stock refresh grants.

Why Should you Care?

When working for a startup, the base salary is often less than the market average. The silver lining is the equity or stock options component of the compensation package, the performance of which heavily influences the financial upside for you as an employee. In working for a large enterprise, the focus is geared towards immediate financial security and long-term retirement planning. Usually, this means looking at things like base salary, healthcare benefits, and 401K match. With a startup, however, there are many other considerations potential employees should understand.

• Risk Tolerance: Since you will likely be taking a hit to base salary, take the time to research and understand if the equity potential outweighs that salary
• Vesting Schedule: When will you earn your shares? Be mindful of the vesting schedule. I just did a quick Google search, and a typical vesting schedule is four years with a 1-year cliff
• Timing: Earlier-stage startups carry more risk; While you will likely get more equity, you will have the trade-off of uncertainty
• Tax Implications: Understand what it means to exercise stock options and the potentially significant impact on your taxes. The following article from Carta explains this in detail

Summary

As technical practitioners, you probably like to stay in your technology lane. When going to work for a startup, you will likely receive an offer that has a three-pronged compensation package, including base, equity, and bonus. You owe it to yourself to understand what growth stage the startup is in, the company’s runway, and how current and future fundraising plans might impact your equity over time. As always, consult with a financial planner and/or tax advisor before making any big decision.