Reactions to my last blog post, Cap Table Changes over Time and Founder Dilution (Excel Worksheet Included), were interesting: There were some founders and entrepreneurs who said that this was a great example how venture capital investors squeeze out founders and CEOs who actually have the idea and are actually executing (versus VCs who just give good advice).
That’s not totally wrong: It’s hard to make money with startups that are more likely to fail than even go sideways. So returns have to be “risk-adjusted” for our portfolio of companies, and the ownership required is a function of exit expectations and portfolio construction. I’ll cover that part in a later post, but here’s an Excel sheet that should explain the basic mechanics of how VCs get diluted over the various rounds, from seed to Series E (if we ever get that far).
Seed Investor Example
Let’s look at a simplified example, without liquidation preferences, management carve-outs, bank loans, warrants, etc. A Seed investor invests $750k in a $1M Series Seed round at a $3M pre-money valuation (Don’t laugh! Yes, these kinds of rounds still exist!). They end up with 18.75% ownership. The Company raises a $4.0M Series A at $16M, and our Seed Investor does a bit over-pro-rata with $1M participation (so far he needs a 1 : 1.3x reserve relative to her initial investment).
So far the Seed investor’s Seed shares got a 20% dilution: She still owns 750,000 shares, but the total number of shares increased from 4,000,000 to 5,000,000. Fortunately, she was able to participate beyond her pro-rata, and together with the Series A shares her ownership increased by about 7% to 20%.
Let’s say the company gets an acquisition offer for $55M that is just to hard to refuse and the company sells.
That’s a 11.0x return for the Series Seed, but only a 2.8x return for the Series A. The combined return is $11.0M for a $1.8M investment, or a 6.3x multiple on invested capital. Sounds good, but if the Series Seed investor has a $75M fund, they have to have more than 20 investments of that sort to return 3x of their fund gross (excluding management fees, syndication costs, operational expenses, and carried interests).
Let’s say the Company continues to thrive and instead raises a new $15M Series B round on a $55M pre-money valuation. Our Seed investor participates with only $2M of that round, as their internal guidance for reserves is a maximum of a 1 : 4 times of the initial investment, and the company seems to be doing reasonably well but is not the next Facebook or Google.
The original 750,000 Seed shares are now part of the 6,363,636 total shares, and the Seed Investor’s original ownership of 18.75% got diluted by more than 37% to $11.79%. The 250,000 Series A shares also saw a 21% dilution, from 5.00% to 3.93%. Overall, the Seed Investor’s ownership is slightly down by 7% compared to the initial ownership.
The Company starts using the money for international expansion and general growth. Unfortunately, they can’t find a repeatable sales motion. The company is not growing fast enough for the appetite of the Series B investor, they cannot find another investor to lead the next round, and the company finds a “soft landing” with a large enterprise acquirer at $95M cash.
Overall, the Seed Investor will return 17.6M, or 23% of the $75M fund. The overall multiple is down to 4.7x: the Seed money has a nice 14.9x, but that was only $750k, compared to the 2.7x larger $2M investment in the Series B that, unfortunately, only saw a 1.4x return. She will have to have over 12 such investments to return 3x gross of the fund.
Missed Series B1 Example
In this example, an investor puts a very small, early check into a Series A financing. The company is struggling to find traction and needs to raise an interim bridge round Series B1. Our investor decides not to participate, the company trajectory is not that great. However, the company is finding product-market-fit and a repeatable sales motion, and the “real” Series B2 is a $25M round at $165M pre-money valuation. Our investor could kick himself for not doing the Series B1 and piles money into the B2: His Seed shares had a 26% dilution, but he is trying to get back ownership with this super-pro-rata investment.
Sale for $350M
The Series A shares are now 26% diluted compared to the initial investment. The return of $25.8M is a 51.6x return of Series A investment cost of $500k, but only returns 12.9% of the investor’s $200M fund. Series B2 only returns 1.8x, or $11.1M, of the $6.0M Series B2 cost, and the overall return is $36.9M, 20% of the $200M fund, at 5.7x. That sounds like a great outcome, but our investor has to make more than 13 of such investments to pay back 2.5x gross of his $200M fund — not an easy task. Maybe our investor would have rather tried and run a bit longer, but the early investors liked their 51.6x+ return.
I can only encourage you to play around with the Excel sheet to understand a little bit about the dilution of early rounds, return expectations, and outcomes for various types of Venture Capital investors.