Came across a wonderful graphic put together by Mark Shuster of VC firm, GRP Partners, that shows just how much a founder’s shares in a business can dilute over time following a series of capital raising initiatives.
Of course your share of the company is going to shrink if you sell off chunks of capital. Many start-ups couldn’t get off the ground without having to raise money at the outset. And raising money no longer includes bank loan finance. Which means shares have to be surrendered.
The hopeful aim is that the money raised will lift the overall value of the business, so that your smaller share of a larger business is ultimately more valuable than a lager share of an uncapitalised business.
Example. You own 40% of a company worth £1m, i.e. £400k. You raise a round of VC, say £2m on a pre-money valuation of £4m, equating to a post-money valuation of £6m. You get diluted by 33% (£2m / £6m) so you now only have 26.67% of the company. But the company is now worth £6m and your 26.67% share is worth £1.6m, a gain of £1.2m.
But then the company grows and further rounds of finance are required. The following graphic shows just how dilution adds up and can sometimes mean that the founders original personal financial expectations might not pan out so well in the end. It’s US-based, but the general math can be applied in the UK. Also remember that in the UK, if the founders are ultimately left with less than 5% each then they become unable to claim the preferential 10% rate of Entrepreneur Relief upon exit, instead being hit with the standard 28%.