Many entrepreneurs are surprised at the suggestion that, if all goes well, they will own 10% to 15% of their company at the time of an Initial Public Offering.  That’s quite a contrast from a current ownership stake of, say, 50% immediately prior to a Seed round.  The difference is the impact of dilution due to multiple rounds of financing.

Investor Expectations

Investors have some general expectations regarding acceptable valuation ranges, appropriate issue sizes, and equity ownership (a function of the other two).  Some “rule of thumb” dilution figures are that:

• Seed Stage financings comprise 20% to 30% of the post-money fully-diluted equity;
• Series A and Series B financings comprise 30% to 40% of the post-money fully-diluted equity;
• Later Stage financings comprise 15% to 25% of the post-money fully-diluted equity; and,
• An IPO is generally for 15% to 25% of the post-money fully-diluted equity.

There is an important “understood” assumption in these rules of thumb.  The company is expected to “top up” its option pool to a standard level each time immediately precedent to a financing.  Typically, an early stage technology company’s option plan is maintained at between 15% and 25% of the company’s fully-diluted equity.  By ensuring these “top ups” occur before a new financing, their dilutive effect only impacts the existing shareholders

Examples

The following two examples give you a better idea of what to expect from the dilutive effects of financings on the VC Path. 

Assumptions for both:

• Seed Round:
  • Issue Size of US$750,000; and,
  • Valuation will be modest (US$1.5 million to US$2 million), recognizing the caution in the current capital markets and intending to ensure the “right investors” come together and do it quickly.
    
    
• Series A Round:
  • Issue Size of US$3.5 million; and,
  • Valuation will likely be more normal, US$5 million or US$6 million.
    
    
• Series B Round:
  • Issue Size of US$12 million; and,
  • Valuation will likely be, US$15 million to US$20 million (1x to 1.25x projected revenue).

Scenario A		Scenario B
strong experienced founding team continuous growth in product development company attracts its intended capital at the most favourable valuations (ie high end of typical range)		less experienced team stumbles, but does not fail in meeting its objectives company attracts its intended capital at the least favourable valuations (ie. Low end of typical range)

While these scenarios provide some realistic parameters, actual valuations will depend on the attractiveness of the given investment and the market conditions at the time.

Appendix 1: Capitalization Structure for Highly Successful Team

The principal founder’s equity ownership is diluted from an initial 75% to just more than 14% at the IPO.  The value of the equity holdings is US$49 million at the IPO

Appendix 2: Capitalization Structure for Moderately Successful Team

The principal founder’s equity ownership is diluted from an initial 75% to just more than 6% at the IPO.  The value of the equity holdings is US$14 million at the IPO.

As demonstrated, the scenario can be very different if the company is unable to attract a highly experienced management team.  Inexperienced managers may fail to meet the intensive demands of a high growth startup – specifically they may be unable to complete product development on time and need to raise new capital without a completed product.  Investors will “penalize” the company valuation because the product development risk remains.  Once over this “stumble,” the company can get back on track and raise new capital at a step up in valuation.

Source: Ottawa Capital Network