What Are Diluted Founders?
As a startup that is using venture capital for funding progresses through multiple rounds, the VCs providing the financing will often want more and more ownership of the company that the founders must surrender in return for the capital received. In short, the founders dilute their ownership in the company in exchange for capital to grow their business.
- Diluted founders is a term often used by venture capitalists (VCs) to describe the founders of a startup gradually losing ownership of the company they created.
- When VCs agree to pump money into a startup, they receive equity shares in return.
- In other words, the founders dilute their ownership in the company in exchange for capital to grow their business.
Understanding Diluted Founders
When an entrepreneur or team of founders launch a startup company, the ownership of the company (or its equity shares) are divvied up among those founders, adding up to 100% in total. This allocation may be an equal split or handed out according to perceived contribution to the new venture, duties and roles, or any other criteria.
Company founders may also contribute (bootstrap) their own startup capital in the form of either cash or sweat equity. In doing so, they might be able to buy greater equity stakes from their co-founders.
Eventually, growing startups will require more capital than they can bring to the table themselves, prompting them to seek outside funding. When investors agree to put money towards a startup, they receive equity shares in return—which must come out of that 100% total pie. This means that as more investors contribute more capital to the startup, the percentage of the company owned by the founders must be diminished.
As more funding rounds occur, early investors, too, become diluted—not just initial founders.
Sometimes, startup founders will carve out an equity slice intended for future investors in advance, so that three co-founders may take 25% of the equity each and leave another 25% as a pool for VCs or other investors. Nevertheless, even this percentage will become diluted over time as seed rounds turn into Series A and Series B capital raises.
Example of Diluted Founders
Company ABC has a pre-money valuation of $3 million before tapping up VCs for some much-needed funding. Series A investors agree to commit $1 million to the company to help it expand, boosting its post-money valuation up to $4 million.
In exchange for that contribution, the VCs now own 25% of the company, leaving the original founders with three-quarters, or 75%. That portion of ownership might be even more diluted should the VCs demand a further percentage be put aside for future employees.
In this case, the VCs want 10% of the founder's stake to be put into an option pool. Such measures might help to attract a talented workforce and promote loyalty among them. However, it also means that the founders suddenly find themselves with 65% of the company they created after just one funding round. In the end, Series A financing diluted their stake by 35%.
Examples of founders getting heavily diluted before making it to the initial public offering (IPO) stage are fairly common. For instance, the co-founders of Pandora Media Inc. (P) ended up with just a 2% equity stake when the music streaming and automated recommendation Internet radio company they helped to create made its public offering in 2011.
This hefty dilution was in part down to unfortunate timing. Tim Westergren and his peers started the company at the height of the dotcom bubble. When the bubble burst, sentiment turned and it became extremely difficult to raise much-needed funds. Pandora was reportedly rejected more than 300 times by VCs. In the end, the company was able to secure capital but only after giving up some fairly big stakes.
What percentage of the company should a founder hold onto, ideally, after the VCs take their piece of the pie? There is no gold standard but, generally, anything between, or above, 15–25% ownership for the founders is considered a success.
Nevertheless, it is important to note that the trade of ownership for capital is beneficial to both VC and founder. Diluted ownership of a $500 million company is a whole lot more valuable than sole ownership of a $5 million company.