

Fear vs. Greed 

Each time founders seek capital they face what my colleague Bill Sahlman refers to as the fear versus greed tradeoff. On the one hand, founders fear that they will be forced to shut down their startup if they run out of money, which leads them to rush to raise new capital.  On the other hand, they are also understandably greedy about maintaining a high equity stake, by minimizing their dilution.  (Dilution is the progressive shrinking of each executive’s equity percentage as the startup raises each round of financing.)  When founders delay raising each round, they are typically hoping to achieve certain milestones that will raise the startup’s valuation. That will reduce the percentage of stock they will have to cede to their financiers, and thus reduce their dilution.

In every round of financing, Zuckerberg and his Facebook team have impressively minimized their dilution.  Our CompStudy data, which allows us to compare Facebook’s equity dilution against that of some 2,500 technology startups, shows how successful the team has been. To estimate how much the founders and other insiders owned after each of the startup’s first three rounds of financing, we used the two major factors that affect dilution: the capital raised by the startup and the pre-money valuation it received. 

As shown in Figure 9.5 of my book, The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup, the averages for technology startups are as follows: 

  • First round: Raise $3 million, with a pre-money valuation of $5 million.
  • Second round: Raise $5.5 million, with a valuation of $10 million.
  • Third round: Raise $7 million, with a valuation of $15 million.

We then compared those numbers to Facebook’s numbers for its first three rounds:

  • First round: Raise $500,000, with a pre-money valuation of about $5 million.
  • Second round: Raise $12.7 million, with a valuation of about $100 million.
  • Third round: Raise $27.5 million raised, valuation of about $525 million.

The resulting difference between the dilution experienced by the Facebook team versus that of the average technology startup is striking across all three rounds, as shown below. 

After his first round of financing, Zuckerberg and the other Facebook insiders still owned about 91% of the equity.  Insiders in the typical startup own only 63% after round one.  As each round progressed, Zuckerberg widened the dilution gap, to the point where after the third round of financing, 77% of Facebook’s equity was owned by insiders, compared to only 27% in the typical startup.

One of a Kind

We then analyzed nearly 2,000 technology companies that submitted data to our CompStudy survey from 2008 through 2011, focusing on the software startups that had raised three or more rounds of financing. When they had finished raising their third rounds, in not a single startup did the founders still own 77%:

Minimizing dilution can come with a stiff price.  Zuckerberg and his team faced tremendous fear-vs.-greed pressures.  At the time of Facebook’s founding, the pressures to quickly raise a lot of money were heightened by the prominence of its major social-networking competitor, MySpace, which had a head start and was better funded.  In the first of Zuckerberg’s decisions to resist the call to grow his company quickly (which would have necessitated raising a lot of capital), he consciously limited the site first to Harvard, then to a hand-picked group of schools, and then to a steadily widening net of potential users.  Yet at the point where the typical startup with a pre-money valuation of $5 million is raising $3 million (and thus relinquishing 38.5% of the company to outsiders), Zuckerberg raised only $500,000, retaining a far higher percentage of his startup for himself and his team.  In the quest to minimize dilution and maximize control, Facebook skated to the edge of the “fear” cliff multiple times in their early days.

An Underappreciated Dilutor: Founders’ Equity Splits

In truth, Zuckerberg was minimizing his dilution even before the first round of outside financing.  A founder’s first real dilution – and often the most powerful – occurs when equity is split with cofounders.  Compared to raising a typical round of outside financing, a founder is  more diluted by adopting a 50/50 co-founding split instead of founding solo, or even taking 70% and giving a co-founder 30% (as Zuckerberg did, regretted, and sought to change). 

By co-founding, a founder is betting that the value added by a co-founder will justify the relinquished equity. Throughout one’s entrepreneurial journey, there is a tension between amassing resources and wealth versus retaining control of the startup.  I call this tension the “Rich vs. King” tradeoff– a topic to be explored in a future column.