What Are Diluted Founders?
"Diluted founders" is a term used by venture capitalists (VCs) to describe the process of a startup's founders gradually losing ownership of the company they created. Startup founders who rely on venture capital to grow their business must surrender more and more ownership of the company in return for the capital received. In short, the founders dilute their ownership in the company in exchange for funding.
- Diluted founders is a term used by venture capitalists 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.
- As a result, 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 launches a startup, the ownership of the company (or its equity) is divvied up among the founders, adding up to 100%. This allocation may be an equal split or handed out according to perceived contributions 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 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 founders can invest 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 capital, the percentage of the company owned by the founders is diminished.
As more funding rounds occur, early investors become diluted too—not just initial founders.
Sometimes, founders will carve out in advance an equity slice intended for future investors. For example, three co-founders may take a 25% equity slice each and leave 25% as a pool for VCs. 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 VCs for funding. Series A investors agree to invest $1 million, boosting the post-money valuation to $4 million.
In exchange, the VCs now own 25% of the company, leaving the original founders with 75%. That portion might be diluted even more 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 and loyal workforce. However, it also means the founders are left with 65% of the company they created after just one funding round. In the end, Series A financing diluted their stake by 35 percentage points.
Examples of founders getting heavily diluted before making it to the initial public offering (IPO) stage are fairly common. For example, Pandora Media co-founder Tim Westergren held just 2.39% of the music streaming company before it went public in 2011.
This hefty dilution was in part due to unfortunate timing. Westergren and his peers started the company at the height of the dotcom bubble. When the bubble burst, sentiment turned and it became difficult to raise funds. Pandora was reportedly rejected more than 300 times by VCs. In the end, the company was able to secure capital only after giving up 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 standard, but generally anything between or above 15%-25% ownership for the founders is considered a success.
Nevertheless, the trade of ownership for capital is beneficial to both VCs and founders. Diluted ownership of a $500 million company is worth more than sole ownership of a $5 million company.