The Trickle-Down Valuation Effect

When I left Microsoft in the late 1990s to join a pre-IPO Internet startup, I got insight from a seasoned investor. “You’ll get diluted,” he said matter of factly, “but make sure you don’t get hosed.”

I nodded but didn’t have a clue what he meant.

Eventually, I came to grasp the sage piece of his advice. On its face, dilution is a very straight-forward concept: Dilution is an increase in the number of shares of a company's stock, which generally causes a corresponding decrease in the stock’s value.

For startups, dilution can occur when the company issues new stock in exchange for fresh capital. This is not necessarily a bad thing for existing stockholders. While your ownership percentage shrinks, the company’s valuation theoretically increases with the infusion of new funds making even the smallest piece of the pie that much more valuable. At least, that’s how it’s supposed to work in theory.

As entrepreneur-turned-venture-capitalist Mark Suster points out in his blog—Understanding How Dilution Affects You—the concept isn’t as simple as it appears on the surface, particularly when you attempt to project the impact it will have on shareholders three or five years down the road.

Using graphics provided by Visual.ly, Suster creates a typical funding pathway for a startup, from angel investment right through to Series C funding—and an exit.

I won’t attempt to boil down the very detailed graphs into a sentence or two, but the picture he paints should be a wake-up call for anyone involved in a startup. What at the front-end of the venture looks like a big payday, can dwindle to a fairly typical paycheck over a five-year average.

The bottom-line is this: If you’re in a startup, you’re going to get diluted, or take a “hair cut,” as Suster puts it. But whether you get a buzz cut or just a little off the sides depends on how closely you pay attention to details along the way.

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Ready to take the dilution risk? Check out these links:

Revenue-based Financing

Nobody Cares … When You Fail

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Mark Pawlosky is a writer for Portfolio.