How to Calculate Dilution in Cap Table?
A capitalization table known as a cap table is a financial spreadsheet typically used in startups to manage the equity in the company. While dilution refers to a reduction in an ownership percentage interest in the company. In essence, dilution occurs when new shares are issued, decreasing the percentage ownership of each share. In this blog post, we will take a look at the basics of the cap table, followed by the process of dilution in the cap table and how to calculate it.
Dilution in the cap table
It is essential for an entrepreneur to know and understand the basic principles of a cap table, which include the total amount of shares issued, the number of common shares, and the percentage of ownership held by each shareholder. The dilution in the cap table refers to the process in which the percentage of ownership of each shareholder is reduced when new shares are issued.
Understand cap table
The cap table is a financial spreadsheet that helps a business track the equity ownership, dilution, and equity value. A cap table should be formed after every round of funding in order to help the business understand its current equity ownership percentage in relation to the new funding round.
How does a cap table work in an organization?
A cap table provides a complete view of the ownership and valuation of each shareholder in the company. This is achieved by defining a company’s share structure and identifying the number of shares issued to each investor. In most cases, the cap table provides a visual representation of the number of shares that are issued to each stakeholder.
This information is then used to determine ownership percentages and any changes in the equity with new funding rounds. Thus, the use of a cap table is to help an entrepreneur understand dilution in a startup and manage it effectively.
Importance of having a cap table in an organization
The cap table provides the entrepreneur, investors, and anyone involved in the company a clear view of the equity and ownership held by each stakeholder. It provides an easy and quick way of tracking ownership for funding rounds or additional investments to obtain financing. Here are some of the benefits of having a cap table in the organization:
- It helps investors understand dilution and its impact on the value of their investment.
- To be able to make the best business decisions, such as constantly evaluating risks, making strategic investments, and conducting track-record management.
- It helps businesses maintain a consistent equity distribution, which is especially important in companies with high-risk potentials.
- Cap tables allow investors and the entrepreneur to analyze the precise value of an organization in terms of its market value, potential equity value, and actual equity value.
- It is crucial for all parties involved in the company to understand their share of the organization’s equity clearly. It helps increase overall transparency and makes it easier for investors, employees, and other stakeholders to assess these percentages.
What is cap table dilution and how does it occur?
The cap table dilution refers to the process of decreasing equity ownership because new shares are issued as a result of a funding round or an investment. The structure of the cap table depends on the type of equity financing used, but generally, it involves adding new shares to the company and reducing the percentage ownership of each shareholder.
If a company accepts capital investments that are not in exchange for ownership interest (such as debt), then there is no dilution. This means that investors need to exercise caution when funding companies because additional shares may be added to an existing cap table, which can positively or negatively impact the value of their investment. Therefore, an investor or entrepreneur needs to understand how the new shares will impact the cap table and its overall dilution.
What is a fully diluted cap table?
In an ideal situation, a fully diluted cap table refers to the complete set of currently outstanding shares for every security and totals from every convertible security in the case where they are to be exercised. Thus, a fully diluted cap table contains the total number of shares that are considered outstanding. This is relevant to business owners who are interested in knowing all potential future sources of equity financing.
How does cap table dilution affect shareholders and organizations?
As long as there is sufficient equity in a company, all owners will benefit from the growth opportunities which remain available to them. However, in a situation where a company’s equity dilution is too high, it will be difficult to attract new investors and will create a situation of weak investors’ support.
This can discourage the investor and force them to divest, especially if they have no potential growth opportunities with limited equity. Thus, equity dilution in a company is a concern for all stakeholders because it can negatively affect the value of their shares. Consequently, a company must strive to maintain its equity dilution to a minimum level because the lower it is, the higher the potential value of the business.
Calculating dilution in the cap table
Once you understand the cap table, it is simple to calculate the dilution that occurs in a business. It is vital to calculate dilution in the cap table, which will occur at each company’s funding round. This can help to determine when and how much equity will be diluted.
Why is it important to understand and calculate cap table dilution?
The cap table dilution is an extremely important aspect of the startup ecosystem—especially for business owners and investors. It plays a significant role in the success and failure of a startup, so understanding it can be beneficial to entrepreneurs and investors. Following are the 5 reasons why it is important to understand and calculate cap table dilution:
- It can help entrepreneurs optimize the value of their business.
- It helps investors evaluate risks and make accurate assessments of a business’s current and future value.
- The type of business can determine the value at which a startup will be acquired or sold to another party.
- It is crucial for decision-makers to track equity dilution and its impact on their company’s valuation as well as overall ownership percentages with each funding round or investment in an organization.
- Knowing cap table dilution in a company is critical for the development of future funding rounds, especially when the company intends to raise new funds from outside sources.
How to calculate dilution in the cap table?
With the easy-to-use formula, cap table dilution is calculated very easily. Firstly, you need to identify the number of outstanding shares in the company and compare it with the number of issued shares. Based on this, calculate the percentage of equity ownership you hold as of now.
Further, when you proceed with rounds of investment, you need to calculate the additional number of shares issued. Then calculate the percentage of ownership after the investment round or after issuing additional shares. Lastly, subtract the percentage of ownership before investment from the percentage of ownership after investment. This will give you the percentage value of dilution. Here’s how to calculate dilution in the cap table:
Understand the dilution formula
Simply, we can calculate dilution in a cap table by subtracting the percentage of ownership before investment (No. of outstanding shares) from the percentage of ownership after investment (No. of issued shares), and the final result is the percentage of equity dilution in the cap table.
For instance, the outstanding shares are 4 million, out of which the founder holds 1 million shares. This means the founder has 25% ownership of the company. When the company raises an additional round of funding, it issues 1 million new shares, and the founder’s percentage ownership drops to 20%. Even though the founder only holds 1 million shares out of 4 million outstanding shares, his percentage ownership is reduced by 5%. Thus, this is the process of equity dilution that occurs in a company, which results in a reduction of the ownership percentage.
Calculate the dilution in investment and ESOP step by step
Now that you understand the cap table dilution formula and how it is calculated, you can calculate the dilution in investment or ESOP. Here we will make a scenario for a startup where the founder holds 100% ownership of the company and how it decreases with each and every factor.
- Hire talent/staff – It is possible that the founder will hire new employees and make them part of the cap table. While it is important to hire qualified and talented employees in order to make your company successful. Assuming you are hiring accountants and giving them 5% of equity. At this point, you should note that the founder’s percentage drops to 95%.
- Raise seed funding – As the company grows and needs capital for expansions and new investments, the founder will continue to raise seed funding rounds. Seed funding is the fundamental model of raising a small amount of capital from a limited number of investors, typically angel investors. In this case, assuming the company is raising seed funding (Series A + B) of 15% and the founder’s percentage ownership drops to 80%.
- Raise Series A – Series A refers to the initial round of investment that is often used to test a company’s viability. It is a term for an investment round that is often followed by a series of more rounds, each of which is called Series B, C, D, and so on. Let us say the company diluted 7%, and the founder’s percentage ownership dropped to 88%.
- Raise Series B – Series B refers to the second round of investment. It is also known as the first institutional round and is typically larger than Series A. Series B investment aims to facilitate growth, which often involves hiring new employees, expanding company operations, and other expenses. In this case, assuming the company diluted 8% and the founder’s percentage ownership drops to 80%. Thus, with both Series A and Series B, the founder’s percentage ownership drops by 7% and 8%, respectively, which means a total of 15% dilution in the ownership. Now the founder’s percentage ownership is 80%.
- Create two ESOP pools targeted at 10% post each raise – In order to protect your startup from outside threats and facilitate growth, it is possible to create an ESOP (Employee Stock Option Plan). The founder can issue ESOPs to employees as part of their compensation package. In other words, founders have the option of issuing shares in order to create a pool and set aside a certain amount for their employees. In this case, assuming the company dilutes 20% and the founder’s percentage ownership drops to 60%.
Cap table dilution with pre and post-money valuation
It is also essential to calculate the cap table dilution with pre and post-money valuation. Pre and post-money valuations represent the company’s worth before an investment round and after an investment round. The pre-money valuation is calculated using all the outstanding shares of the company.
Similarly, the post-money valuation includes the issuance of additional shares as well as other instruments. Calculation of cap table dilution is calculated as per the pre and post-money valuation. Thus, it is very important to understand how pre and post-money valuations are calculated and how they are performed.
Can dilution generate value?
When a company raises capital, it will be expected to give up a portion of ownership to the investors. This is referred to as dilution. The key question that arises here is can we generate value with dilution? In other words, can we still create wealth even though we are giving up equity in our companies? Well, the answer is yes!
Even though you may dilute your ownership by granting stock options or selling shares, you could still be creating value at the same time. This is possible because equity dilution is not always negative. However, if you do it in a smart way, it could generate great value for your company. This is possible by leveraging the advanced technologies and tools that are available in today’s world. The bottom line is that you have to do it in a structured and well-managed manner if you want to achieve value.
Manage your cap table with Eqvista to keep an eye on equity dilution
Understanding the fundamentals and key aspects of cap table dilution is very important in order to sustain your business. You will be able to make the right decisions in terms of managing your company, as well as enhancing your market share. In addition, you will be able to derive immense value for your business if you are able to use the cap table effectively. Proper management and control of dilution in the cap table are essential in order to achieve business goals. It is very important to understand the various factors of capital raising, business planning, and cap table management as a startup entrepreneur. Eqvista has created a one-stop platform that allows you to manage your cap table and control the process of dilution. Eqvista understands growth-stage businesses, so it can work with your company to achieve success. The team has the expertise and experience to guide you in the right direction.