Investing early into a company can bring outsized returns to investors when the company exits. Early investors can access lower valuations than later-stage investors and generate higher returns. At least, that’s in theory. A couple of elements, such as the type of securities bought, the liquidation preferences of other investors, and dilution, can diminish an early investor’s returns.

While dilution is a natural part of investing in early-stage startups, understanding how it works can help investors accurately project their future returns.

What is dilution?

When a company needs more capital to fund its operations, expansion, or other activities, it may choose to issue new shares of stock. This increases the total number of outstanding shares in the company, thereby reducing the ownership percentage of existing shareholders. This is because the total number of shares increases, but the existing shareholders do not receive a proportional increase in their shares.

Dilution can impact the value of each existing share. If a company issues more shares without a corresponding increase in its overall value or earnings, the value per share may decrease. This can affect the value of an early-stage investor’s initial investment.

Some investment agreements include anti-dilution provisions to protect early-stage investors. These mechanisms adjust the number of shares the investor holds in response to subsequent issuances at a lower valuation, mitigating the impact of dilution. However, these protections only apply to preferred stock and are rare in equity crowdfunding offerings.

Let’s do the math

Imagine that Riley is an early-stage investor who invests $100,000 in a startup with 1,000,000 shares outstanding at a $1 price per share. In this case, Riley’s ownership stake is 10% (100,000 / 1,000,000).

Now, let’s say the company needs additional funding and decides to raise $1 million by issuing 500,000 new shares, at a price of $2 per share. After this fundraising round, the total number of shares outstanding becomes 1,500,000 (1,000,000 existing shares + 500,000 new shares), and the company is valued at $3 million.

If Riley’s investment remains the same at $100,000, Riley’s ownership stake is now diluted because 100,000 shares represent a smaller percentage of the total shares outstanding. Let’s calculate the new ownership stake:

Currently, Riley owns 6.67% of the company, not 10% anymore. However, because the share price increased from $1 to $2, Riley’s 100,000 shares in the company are worth $200,000. Dilution is a normal consequence of a startup raising subsequent rounds, and most new rounds bring the company’s share price up, thus benefiting early investors. Even if dilution is negatively connoted in investor’s minds, it mostly negatively impacts investors when the startup raises a down round (a round at a lower valuation than an investor’s initial investment).

Time evolution

Let’s now apply this technique over a couple of rounds in the life of an imaginary startup to understand the impact of dilution on Riley’s common shares in an example where the initial Friends & Family investor doesn’t re-invest in future rounds.

This example simplifies reality by taking a company with a constant increase in valuations and a favorable and reasonable exit. To simplify, the example and focus on the effect of rounds on dilution, the example implies that no investors have liquidation preferences higher than 1x.

Round Price per share Number of Shares outstanding post-round $ Amount raised Post-money Valuation Riley’s shares Riley’s ownership Riley’s shares’ value Riley’s return
Friends & Family $1 1,000,000 $100,000 $1 million 100,000 10% $100,000 1x
Pre-Seed $2 1,500,000 $1,000,000 $3 million 100,000 6.67% $200,000 2x 
Seed $4 2,000,000 $2,000,000 $8 million 100,000 5% $400,000 4x
Series A $5 4,000,000 + 500,000 stock options = 4,500,000 $10,000,000 $22.5 million 100,000 2.22% $500,000 5x
Series B $7 7,500,000 + 500,000 = 8,000,000 $21,000,000 $56 million 100,000 1.25% $700,000 7x
Series C $7.5 28,000,000 $150 million $210 million 100,000 0.357% $750,000 7.5x
Acquisition $10 28,000,000 0 $280 million 100,000 0.357% $1,000,000 10x

Because of dilution, in this case, an investor’s return doesn’t increase with the company’s valuation but with the price per share. In this example, the valuation needs to go up by 280x for Riley to get a 10x return on the initial Friends & Family investment. 

A real-life example recently happened when Monogram Orthopaedics launched an initial public offering after raising online rounds. Investor’s returns was lower than the company’s valuation increase.

This reduction in ownership percentage results from the company issuing additional shares to raise capital. While dilution is often necessary for a company’s growth and development, investors need to consider the starting valuation, the company’s prospects, and any protective mechanisms in place (such as anti-dilution clauses) to make informed investment decisions.

Dilution in a SAFE

In a Simple Agreement for Future Equity (SAFE), dilution operates differently compared to traditional equity ownership, primarily because SAFEs don’t undergo dilution until they convert to equity. This unique characteristic provides a hidden benefit for investors, especially when considering the conversion timing. Investors should consider whether they hold a pre- or post-money SAFE, particularly when contemplating conversion.

With SAFEs, investors don’t initially hold actual shares in the company. Instead, they possess the right to acquire shares in the future, typically triggered by specific events like a priced equity round or acquisition. The conversion of SAFEs into equity occurs at a predetermined discount or valuation cap specified in the agreement, diluting existing shareholders.

However, future dilution only affects SAFE holders once the company chooses or is forced to convert their SAFEs into equity. Holding onto a SAFE without converting can be advantageous, especially if the company defers conversion until a later funding round. In such cases, investors can delay dilution and potentially benefit from holding onto their stake until a more favorable valuation is reached.

Investors should consider the conversion timing and whether it aligns with the company’s growth trajectory and valuation. Additionally, understanding whether they hold a pre- or post-money SAFE is crucial, as it can significantly impact the number of shares received upon conversion and the extent of dilution experienced. A pre-money SAFE sets the valuation of a startup before investment, while a post-money SAFE determines the valuation after investment. Investors typically get the most shares when using a pre-money SAFE, as the valuation is set before their investment, potentially allowing them to secure a larger ownership stake at a lower valuation than a post-money SAFE. By evaluating these factors, investors can make informed decisions about their investment strategy and maximize their potential returns in early-stage startup investments.

Let’s do the math (again)

Let’s get back to Riley’s investment in our imaginary startup. In this case, Riley invested $100,000 at a $1 million post-money valuation cap SAFE during the Friends and Family Round.

Round Price per share Number of Shares outstanding post-round $ Amount raised SAFE Valuation Cap Post-money valuation Riley’s shares Riley’s ownership Riley’s shares’ value Riley’s return
Friends & Family 900,000 $100,000 $1 million 0 10% 0x
Pre-Seed 900,000 $1,000,000 $3 million 0 10% 0x
Seed 900,000 $2,000,000 $8 million 0 10% 0x
Conversion Event triggered at Series A $2.84 2,812,500 $8 million 281,250 10% $798,750 7.99x
Series A $5 4,812,500 + 500,000 stock option = 5,312,500 $10,000,000 $26.56 million 281,250 5.3% $1.4 million 14x
Series B $7 8,312,500 + 500,000 = 8,812,500 $21,000,000 $61.68 million 281,250 3.2% $1.9 million 19x
Series C $7.5 28,812,500 $150,000,000 $216 million 281,250 0.97% $2.1 million 21x
Acquisition $10 28,812,500 0 $288 million 281,250 0.97% $2.8 million 28x

In a post-money SAFE, investors lock in a percentage of equity until the conversion event. Therefore, in our case, Riley is ensured to own 10% at the time of conversion.

During the conversion event, the shareholders’ ownership percentage is kept :

  • Riley will own 10% and, therefore, be issued 281,250 shares
  • Pre-seed investors will own 33% and be issued 928,125 shares
  • Seed investors will own 25% and get 703,125 shares

Upon conversion, the company issues 1,912,500 shares that add to the founder’s initial 900,000 shares to keep the SAFE investor’s ownership percentage. The seed investors received 703,125 shares for its $2 million investment, therefore the company’s share price at conversion is $2.84 per share. 

Overall, a SAFE protects early investors against harsh dilution. In our first example, Riley’s ownership diminished from 10% in the Friends & Family round to 2.22% in the Series A round. With a SAFE, Riley owns 5.3% of the company at the time of the Series A.

Thanks to a SAFE, Riley gets a 28x return on the Friends & Family investment instead of 10x on a regular common stock investment.

Anti-dilution Provisions

Anti-dilution rights come in two main forms for preferred stock owners: full ratchet and weighted average. 

Note that anti-dilution provisions are much rarer in investment crowdfunding rounds and are typically reserved for larger Venture Capital and institutional investors.

Full Ratchet Anti-dilution:

Full ratchet anti-dilution is a more aggressive method of protection. With full ratchet, if new shares are issued at a lower price than investors initially paid, their original preferred stock investment is retroactively adjusted to match that lower price per share, which will give them a more favorable conversion ratio. Essentially, this means that at the time of conversion (which can be at a later round), regardless of the size or terms of the new issuance, the investor’s share price will be converted and reset to the lowest price at which new shares were sold, and the corresponding additional shares will be issued as common shares. While full ratchet provides maximum protection for early investors, it can be seen as punitive to the company and later investors because it significantly reduces the value of their shares.

Let’s go back to the example where Riley invested $100,000 of preferred stock at a $1 share price in a company worth $1 million during a Friends & Family round. In this scenario, Riley would own 100,000 shares. But if the startup were to raise funding at a $0.5/share in pre-seed, Riley’s shares in the company would only be worth $50,000. With the anti-dilution ratchet, Riley would automatically be issued new common shares at the lowest price per share to match the initial value of the Friends & Family investment if they choose to convert. In this case, Riley would obtain 100,000 more shares. Riley would then own 200,000 shares worth $100,000 and wouldn’t face the depreciation of its investment value because of new investors. 

In a situation where only early investors would gain from this protection, later investors who came in after Riley but before the down round would find their ownership in the company reduced because the early investors would have more shares. Dilution mostly has negative effects on investors when:

  • Investors want voting power. Dilution will reduce their power.
  • The company’s overall valuation struggles to increase. If the issuance of new shares for investors protected by the anti-ratchet dilution overinflated the value of the company, the share price may stay stable or barely increase.

Narrow-base Weighted Average

Narrow-base weighted average, on the other hand, is a more balanced approach. This method considers the old and new share prices when adjusting to the original investor’s shares. It involves a formula determining the number of old and new shares and their respective prices. Using a weighted average calculation makes the adjustment fairer to all parties involved. It ensures that existing investors are protected from substantial dilution while considering the company’s and new investors’ interests. Weighted average anti-dilution rights aim to strike a compromise between protecting early investors and maintaining the company’s ability to attract future funding at reasonable terms.

Let’s use Riley’s example one more time. Like in the full-ratchet example, Riley invested $100,000 of preferred stock at a $1 share price in a company worth $1 million during a Friends & Family round and owns 100,000 shares. However, in the pre-seed round, the startup raised $1 million in funding at a price of $0.5/share, and Riley’s shares in the company are only worth $50,000.

With the weighted average anti-dilution protection, Riley’s shares will not be adjusted based on the $1 initial share price like with the full-ratchet protection, but based on the average between the $1 initial share price and the weighted average new investor’s share price. At the time of conversion, which can happen in a later round, the calculation will as follows:

Riley’s adjusted share price 

= (outstanding shares + amount to be raised in new round) / (outstanding shares + number of shares to be issued in new round) 

= (1,000,000 + 2,000,000) / (1,000,000 + 4,000,000)

= $0.6/share

Therefore, Riley’s 100,000 preferred shares will be adjusted to a total of 100,000/0.6 = 166,667 shares thanks to the weighted average protection at the time of conversion. If conversion happened during the current round, Riley’s shares would be worth $83,333.

More experienced investors will notice that while the conditions and applications of weighted average anti-dilution protection vary, most crowdfunding investors simply need to understand the protection concept to make smart investment decisions.

While both full ratchet and weighted average anti-dilution mechanisms protect investors from dilution, they vary significantly in their impact on the company’s capital structure and attractiveness to potential investors. Investors must carefully consider the implications of each type of anti-dilution provision before committing to an investment. Understanding these nuances empowers investors to assess the risks and benefits of equity crowdfunding opportunities more effectively, ultimately enabling them to make more informed investment decisions.