A major concern for many first-time founders is share dilution, which is the reduction in the value of an individual's ownership stake in a company. Share dilution often occurs when a company raises capital through the issuance of new shares, which decreases the percentage of ownership that existing shareholders hold.
In this article, we’ve outlined some major strategies for first-time founders to help manage share dilution.
Raising the right capital
You can minimize share dilution when you raise the right amount of capital. Before fundraising, accurately access the financial needs of your company and ensure that the amount you are requesting is the actual amount you need to achieve the business goals that you’ve set in place. When you raise excess capital, it can cause a share dilution on your cap table and also cause increased pressure to achieve higher returns for your investors.
Use convertible notes
Another strategy to minimize share dilution is to use convertible securities such as convertible notes instead of common stock. Convertible notes only dilute share ownership when they convert. Until then, they remain as convertible notes (debts, simple agreements for the future are equity), and only dilute share ownership on the agreed date that they become shares. What this means is that your investors are investing in the potential of the company, not its current value.
Implement a share buyback program
A share buyback program allows a company to purchase its shares on the open market thereby decreasing the number of outstanding shares and increasing the value of the remaining shares. If you create a plan to buy back shares, when your company generates more cash, it can be used to buy back the shares and thus decrease share dilution.
Negotiate with investors
A first-time founder often has more leverage in his first fundraising round. You can help limit the dilution by negotiating properly on the number of shares to be issued in the funding round. You can do this by setting a cap on the number of shares to be issued thereby limiting the dilution.
Communicate with shareholders.
Always communicate early with your shareholders on the dilution of shares as this will make them more supportive of decisions. Inform the shareholders about the financial performance and every future plan that is being worked upon as you build the company. Your shareholder's understanding of the company’s plan and direction is essential to move the business forward.
Share dilution is essential and can be managed properly through strategic decision-making. A first-time founder who is focused on raising the right amount of capital and using the approaches mentioned above is on the right track to minimize share dilution.