Cap table dilution formula step by step example

This is the second part of the Pro Cap Table training course on the dilution formula. In this series we go through the basics you need to know, then worksheet by sheet so you know how to make a seriously kick-ass cap table.

Today’s session is going to be simple, we’re going to explain how Cap table dilution works.

We aren’t going to do the absolute basic version, as we’re also going to learn about the impact of ESOPs (Employee Share Ownership Plan) on this ‘dilution’ too. In this way, you can understand how your staff gets rich too.

Tool for understanding basic cap table dilution

This is what the sheet looks like that we are going to go through:

You can download it here:

DILUTION TOOL

Video on Cap table dilution

If you like to watch videos instead, I have you covered. You can start with the video and work through the text guide if that helps you learn better.

Introduction to startup dilution formula

You start owning the whole of your company, and if you bootstrap and don’t give any shares to the staff you will continue to own all of it. But that’s not normal for most tech startups these days, since, along the way other people get a cut of your company and so upside when you hopefully exit.

Others getting a cut is called dilution, and it’s what we are going to get into in detail.

Dilution happens as shit happens. If you raise money, hire staff, engage in M&A, or give shares to lawyers when you are broke, you are going to get diluted.

What does the equity dilution formula mean?

Simply put, it means that your relative ownership stake in your startup is reduced. For instance, if your company is sold for $100 million, you won’t receive the entire amount because other shareholders are entitled to their share of the proceeds.

Each time there’s a dilutive event, everyone on the cap table gets diluted proportionately, unless they have special rights that protect them from such dilution, like in the case of a down round with full-ratchet anti-dilution provisions.

The earlier someone becomes involved in the company—either as an investor or a team member—the more they experience dilution since they are subject to dilution at each subsequent event. This means that founders, who are the initial owners, face the highest degree of dilution.

Think of dilution and ownership like a pie

Think of your startup as a whole yummy pie. This pie represents the total ownership of the company. When you first start your business, you own the entire pie, meaning you have 100% ownership of your company.

But you are ambitious and in order to sell it faster and for a tonne of mullah more, you need to wait five years and during that time, to survive, you have to give a slice of it to others. You can’t make the pie bigger. It’s fixed and crusty, right? BUT, you can make that pie worth a whole lot more when MR. Money Bags comes-a-shopping!

Sharing the Pie

As your startup grows, you’ll likely need additional resources to expand, such as funding from investors or the skills and time of employees and advisors. To gain these resources, you have to give away pieces of your pie in exchange.

Bringing in Investors

When you bring in investors, you are essentially giving them a portion of your pie in exchange for their investment (funding). For example, if an investor puts in money and you agree to give them 20% of your company, you are giving them 20% of your pie. Now, you’re left with 80% of the pie, and the investor has a 20% share.

Hiring Employees and Advisors

Similarly, when you hire key employees or advisors, you might offer them stock options as part of their compensation. This means you are giving them a small slice of your pie. Every time you give someone stock options, the size of your slice gets a little smaller.

For example, let’s say you own 100% and give away 10% of your shares to early staff. If you own 100 shares and give away 10%, your ownership is now calculated as 100/111, which is approximately 90%.

Subsequent Funding Rounds

As you go through more funding rounds, like Series A, Series B, etc., you will give away more slices of your pie to new investors. With each round, your piece of the pie continues to shrink, although the hope is that the pie itself will become more valuable over time.

Dilution of Your Slice

Each time you give away a part of your pie, your ownership percentage decreases. This process is called dilution. Initially, you owned 100% of the pie. If you give away 20% to investors, you’re left with 80%. If in a later round, you give away another 10%, you’re now down to 72% of a larger pie (80% of your remaining 80%).

The Growing Value of the Pie

It’s important to remember that while your slice of the pie becomes smaller, the overall value of the pie is ideally growing. This means that even a smaller percentage can be worth more in the long run if your company increases in value.

So now we see that giving shares to people is not free, understand that ESOPs aren’t free either. We are going to work through a step-by-step example now with numbers in detail.

Step-by-step example of dilution with investment and ESOP

The basics you absolutely want to understand if you plan to raise is how much investors will take of your startup. We will 100% do this, but the impact on staff isn’t normally explained and it’s important too.

Employee Stock Ownership Plans (ESOPs) also contribute to dilution. They are not cost-free and result in a reduction of the founders’ ownership percentage. Let’s explore this with a detailed, step-by-step example.

Introduction to the ESOP example

To understand how investment rounds and ESOPs affect your ownership, let’s create a scenario where you:

• Start with 100% ownership.
• Hire staff.
• Raise a seed round, followed by Series A and Series B.
• Create two ESOP pools, each targeted at 10% post-each fundraising round.

At each stage, you can see how your ownership decreases progressively from 100% to 41%.

First hires

It begins. You start and own 100% in common, founder stock. The whole pie.

Next, you need to add some great engineers to your team to get product/market fit to be in a position to do your seed round. Typically you will give 5-10% of your company to these early, star-eyed staff. This can be done in options but often you can use “founders stock.”

We will use 10% for the dilution.

The result: is you own 90% of the company and your new engineers own 10%.

Seed rounds

Great, the staff kicked ass and you got traction, time to go raise the seed round. You give yourself 6 months to get the round done, but it only takes you 4 months. You find and settle on a nice seed stage fund.

You know these seed-stage investors require 10 to 25% of your startup to make their business model work. Fortunately, they love you, and with some savvy negotiation, they invest for 10% equity.

The result: you own 81% of the company, your engineers have 9% and the investors have 10%.

How does the math work? Well, you multiply the holding you had before by the ownership position of the investors. So 90% times 90% is 81% and for staff 90% times their 10%, resulting in 9%. Simple, right?

To take the Udemy course on how to structure ESOPs head here.

Series-A

Fab. The seed helped you scale up and now it’s time to put some fuel on the fire. It’s time for the fabled Series-A.

Things are looking up and you’ve beaten the odds to get here. You had an 18-month runway (Download the runway calculator) with your seed, and you planned after 12 months to start raising to get a full year of execution and 6 months to get the next round done.

Your seed investors introduce you to Blue Shirt Capital who do series-a and beyond. They like you. Blue Shirt negotiates for 20% of your company and demands a 20% ESOP post-raise. You show them your hiring plan and negotiate them down. They now require a smaller ESOP of 10%.

The value of the ESOP is taken out of the “pre-money valuation,” which means the dilution from the option pool is taken before the VC investment and your effective pre-money valuation is lower than what you thought, but hey, you need the cash.

Before we look at the series-a math, let’s look at what needs to happen with the first ESOP you are going to have to make.

ESOP #1

The investors want a 10% pool post Series-A. But you are not diluted 10%, you are diluted 12.5%! Wtf? Why?

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.

Effective dilution: ESOP percentage / (1 – investment dilution percentage)

So how does the math work? The dilution at series a is 20% and the ESOP is 10%. So you divide the ESOP (10%) by 1 minus the dilution you have (20%). That rounds up the amount to the amount pre-investment of 12.5%. The formula is =10%/(1-20%)

That 12.5% is then diluted proportionally against all shareholders and 12.5% is added to the ESOP line. Everything adds up to 100%.

The result: So pre the raise but post the ESOP, the founders now own 70.9% (81% times 87.5%, which is 1 minus the 12.5%), the engineers own 7.9%, and the seed 8.8%.

Series-a dilution formula

When the series-a investment closes, everyone is getting diluted 20% other than Blue Shirt who are just getting on your cap table now.

The result: the founders now own 56.7% (70.9% times 80% which is one minus 20%), the engineers own 6.3%, the seed investors own 7%, Blue Shirt owns 20% and there is a post-raise ESOP of 10%. This all adds up to 100% again

Series-B

Whoop whoop! You made it to the promised land of Series-B, and you are clearly doing something right! Blue Shirt introduced you to Khaki Co. who decided to do the whole deal for 25% and need you to top up the ESOP pool to keep it at 10%.

Now the math is a little funkier here in how you calculate the ESOP and dilution, otherwise, everything is the same math as before.

Note, that this model assumes that you do not issue any shares to staff to make it easier to follow. In the real world, your unissued ESOP will be far smaller so your dilution to top up the ESOP will be larger! Understand?

ESOP math

Let’s start with how dilution is calculated. The goal is to have 10% post-investment. But this time you already have ESOP left already. That amount of the investment is 10% too, but it needs to get diluted. So let’s look at the formula:

• You gross up the 10% ESOP you need post-raise by dividing it by 1 less the 25% investor stake.
• Then you deduct the ESOP you already have which is 10%.
• Now, since the ESOP top-up is going to dilute you before the investment, you also gross up the top-up amount by 10%. So the dilution is not 3.33% but 3.67%

All the shareholders get diluted by 3.67%. You can see that the first, original ESOP is now 9.6%. I have added a line for ESOP number two which splits out the top-up amount. That is 3.7%. If you look at the total ESOP line you can see that the total ESOP pre-raise equals 13.3%.

Series-B math

Let’s look at the series-b math dilution formula now. All the math is the same as we have done before. You just dilute everyone by 25%. If you look at the ESOP total line you can see it adds up to 10%.

The result: What is the end result of all the financing and ESOPs? You own 41%. You engineers who started with 10% now own 4.6%, but of a more valuable company. Your seed investors are down to 5.1%. The series-a chaps who started with 20% are now holding 14.5%. The series B chaps have not been diluted so they own 25% still. Finally, in total, the ESOP is 10% of your startup.

Conclusion on the dilution formula

Congrats, you have got through the dilution and ESOP math! It’s a lot to take in, but go through the model cell by cell and you can figure it out. Yes, it’s boring but you need to learn.

Navigating through dilution and ESOP calculations can be complex, but understanding each step is crucial. The key takeaway is to recognize the impact of dilution from fundraising and the cost of creating ESOPs pre-funding, which affects existing investors but not new ones. This is why new investors often advocate for larger ESOP pools.

With this foundation, we’ll next delve into cap table dilution mathematics in more detail.

Read next step

 

14 parts in this guide

You can jump to a section if you prefer:

1. What is a cap table and other important questions
2. Cap table dilution step-by-step example
3. Cap table dilution math
4. Starting the cap table (The drop-down menus we need)
5. Shareholders sheet
6. Deal calculations
7. The cap table sheet
8. The assumptions sheet
9. Individual shareholder returns sheet
10. Returns waterfall calculation
11. The ESOP sheet
12. The Common sheet
13. The convertible notes and warrants sheet
14. The preference shares sheets (From Series A to I)