Minimizing Founder Dilution
The Series A round is typically the most dilutive round for founders because the Series A investors have high ownership target and demand a large option pool to build a strong team early on. But there are strategies that founders can use to lower that dilution
Ultimately, the best defense against dilution is execution: the better the company performs, the higher its valuation, and the more cards a founder has during the negotiation. But beyond executing your way to high valuations, here are a few other ideas:
1. Get a Second Term Sheet
A second term sheet (or BATNA - Best Alternative To a Negotiated Agreement) is your best negotiation tactic. It provides leverage by showing other investors are interested, It creates competition, and it gives you options if negotiations with the lead investor fall through
To get a second term sheet while maintaining professionalism:
- Create urgency by setting a clear timeline for your fundraising process
- When speaking with investors, mention you’re in advanced discussions without naming specific firms
- Focus on your company’s strengths and growth potential rather than other offers
- Use phrases like “we’re seeing strong interest” or “we’re in late-stage discussions with several firms”
Remember, the goal is to generate genuine interest, not to simply shop around an existing offer. Be transparent about your process while maintaining discretion about specific details particularly who the other player are.
2. Negotiate Down the lead’s Ownership
Series A leads often start negotiations with a high ownership targets—around 15% but some as high as 20%. These numbers are always up for negotiation. If the proposed capital is more than you actually need, try to negotiate down the round size (or, if you have other investors you want to bring, negotiate down the lead investor’s check size).
3. Offer Other Attractive Terms
Consider conceding on other terms like board structure, information rights, more protective provisions or major investor rights in exchange for lower ownership. But don’t give away too much board control or roll the ownership can down the road by offering super pro-rata. That will come back and bite you.
4. Negotiate a Smaller Option Pool
Investors often require a company to set aside a significant option pool (10%-12%) for future employees, which dilutes existing shareholders. Negotiating a smaller option pool (say 5-8%) will substantially reduce the dilution from the round. However, expect significant investor push back. And if your executive team is thin, your lead might refuse.
5. Re-negotiate Pro Rata Rights for Early Investors
Investors understand that founders can be very sensitive towards dilution particularly if the round starts to balloon. Often founders can go back to their existing investors during the round and ask them to relinquish part or all their pro-rata rights. The best strategy here is to get your most friendly investor to agree to a reduced pro-rata, then call all the others and let them know that you will reduce pro-rata for all investors equally and that one / your lead has already agreed.
6. Negotiate a Founder Grant
Another approach is to agree with the lead investor on the option pool but also ask that a small percentage, say 1% or 2%, are granted to the founder post financing. This approach works best if the CEO’s ownership has fallen below an acceptable threshold (say 20% at the A or 10% at the B) making the case for a small uptick. Investors will push back: existing investors will push back at getting diluted relative to founder and new investors, while new investors will push back on having a smaller option pool available for new hires than originally planned. So tread carefully.
Beyond the 6 strategies above, there are strategies founders can deploy well in advance of the round to minimize their dilution including the following :
7. Start with Fewer Co-founders
A company with three equal co-founders at 33% each is a captable disaster in the making: By the time the company reaches a Series A the CEO could well have less than 20% ownership. So think thoughtfully about who should be a co-founder and what ownership they should have. It’s no secret that first-time founders tend to have multiple co-founders, while more seasoned founders tend to have at most one co-founder and retain the majority of the cap table at founding.
8. Limit Pro Rata Rights for Early Investors
Seed fund investors typically ask for pro rata rights, but it’s advisable to only grant these rights to your larger investors—typically those who have invested $500K or more. This ensures that only significant investors can maintain their ownership percentage, thereby limiting the overall dilution in your next round
9. Raise More Earlier
One way to minimize dilution is to raise a larger Seed round or a follow-on seed extension with small dilution to the founder. By securing more capital during the seed stage, you can delay the need for Series A funding, giving your company more time to grow and potentially achieve a higher valuation, which in turn reduces the dilution percentage when you do raise Series A.
10. Build Something People Want
It’s a simple fact that’s often forgotten: the more you have product-market-fit, the less you sell in any financing round. Some of our best portfolio companies have skipped a round altogether, jumping straight from a Seed to a Series B and skipping all the dilution that takes place in an A.
An ending note:
Remember, negotiation is a normal part of the fundraising process. With clear communication and a strong value proposition, you can often find a middle ground that works for both parties.