Everyone generally agrees that dilution should be avoided. VCs insist on pro-rata rights to avoid the dreaded “D” word. Executives often complain, after a new financing, that they should be “made whole” to offset the dilution that came with the new round. Founders work as hard as they can to maximize their valuation at each financing event to avoid painful dilution. Dilution = bad.
And yet, entrepreneurs want to raise money. In many cases, they want to raise lots of money. There is great pride in the amount of money that is raised and a larger raise is typically celebrated as a greater success. This is a bit confusing, given that a larger raise should also mean more of that awful dilution that everyone is trying to avoid.
Financing events are misleading
Most people in the startup ecosystem think of dilution as the percent of the company that is sold in a financing transaction. If your startup completed a $5 million Series A on a $20 million pre-money valuation, (option pool aside) you would have 20 percent dilution, and everyone will own 20 percent less than they did before the transaction. This is very misleading.
While every equity holder may own 20 percent less of the company than the day before the financing, the company is worth more than the day before the financing. Even if you assume that the valuation was an objective measure of the value of the company and was flat from the previous financing, everyone now also owns their percentage share of the new cash that was added to the cap table, which wasn’t part of the company’s value prior to the financing. Here’s an example:
Your Dollar Value
So if you owned 10 percent of the company, and the day before the financing that was worth $2 million, the day aft