How Startup Dilution Works: Pre-Money, Post-Money, and the Option Pool

Pre-money, post-money, and the price per share

The founders own 10,000,000 shares between them. A seed investor offers $2 million at an $8 million pre-money valuation, which is the company's agreed value before the new money arrives. Post-money is simply pre-money plus the investment: $10 million.

The price per share comes from the pre-money: $8 million divided by the 10,000,000 existing shares is $0.80. The investor's $2 million buys 2,500,000 new shares. There are now 12,500,000 shares in total, and the investor owns 20% of them, which is $2 million out of $10 million. The founders own the other 80%.

Their stake is diluted from 100% to 80%, and it's now worth $8 million on paper instead of nothing in cash. That's the trade every round offers.

The option pool shift

A year later the company raises $5 million at a $20 million pre-money valuation, so the post-money is $25 million and the new investors own 20%.

The term sheet also asks for an option pool: shares set aside to grant to future employees, sized at 10% of the company after the round. The detail that matters is where those shares come from. Investors usually ask for the pool to be created before their money goes in, so it dilutes the existing shareholders and not them.

The result: Series A investors own 20%, the pool 10%, and everyone who was already there shares the remaining 70%. The founders' 80% becomes 56%, and the seed investor's 20% becomes 14%.

Put another way, the headline said $20 million pre-money, but the existing shareholders' 70% of $25 million is only $17.5 million. The pool took $2.5 million of value out of the pre-money. Founders negotiating a round should look at the pool's size as closely as the valuation, since a bigger pool is a lower price in disguise.

Why dilution can still make founders richer

After the seed round the founders' 80% of a $10 million company was worth $8 million on paper. After the Series A, 56% of $25 million is $14 million. They own less of the company and more value.

That's the logic of raising money at rising valuations: each round should buy enough growth that the smaller percentage is worth more than the larger one was. Rounds raised at a lower valuation than the last, called down rounds, break the pattern, and they often trigger anti-dilution terms that hand earlier investors extra shares at the founders' expense.

What liquidation preferences do at a sale

Investors almost always buy preferred stock, and preferred stock usually carries a liquidation preference: the right to get their money back before common shareholders, who are mostly founders and employees, receive anything.

Suppose the company sells for $8 million. A naive reading says the founders' 56% is worth $4.5 million. With the standard 1x preference, the Series A investors take their $5 million back first and the seed investor its $2 million, leaving $1 million to be shared among everyone holding common stock. The founders' 56% is suddenly a share of $1 million.

In a large sale the preferences stop mattering, because investors do better converting to common and taking their percentage. They bite in modest outcomes, which are more common than the large ones. That's why the terms on a term sheet deserve as much attention as the valuation on it.

SAFEs, notes and the dilution you haven't seen yet

Early companies often raise on SAFEs or convertible notes, which turn into shares at the next priced round, usually at a discount or subject to a valuation cap. Until then they don't appear as shares on the cap table, which makes it easy to forget they're coming.

Model them before you need to. Several SAFEs with low caps can convert into a much larger slice of the company than the founders expected when they signed each one separately.

Vesting protects the founders from each other

Founder shares are commonly subject to vesting, often over four years with a one-year cliff: nothing vests in the first year, a quarter vests at the one-year mark, and the rest vests monthly after that. If a co-founder leaves after six months, they don't walk away with a quarter of the company.

Investors expect it, and it protects the founders who stay at least as much as it protects the investors.

Key takeaways

• Post-money equals pre-money plus the investment; the investor's ownership is the investment divided by post-money.
• An option pool created before a round dilutes existing holders only, so a larger pool is effectively a lower valuation.
• Dilution is fine when each round raises the company's value enough that a smaller share is worth more.
• Liquidation preferences pay investors back first, which can shrink the founders' take in a modest sale far below their percentage.

Frequently asked questions

How much equity do founders usually give up in a funding round?

It varies with the stage, the amount raised and the market. Rather than aiming for a typical percentage, founders usually work backward from how much money the next milestone needs and what valuation the business can justify, then check the resulting ownership against what they'll need for later rounds.

What's the difference between pre-money and post-money valuation?

Pre-money is the value agreed for the company before the new investment. Post-money is pre-money plus the investment. An investor's ownership after the round equals their investment divided by the post-money valuation.

Does dilution affect employees with stock options?

Yes. Options represent a claim on shares, so new shares issued in a round reduce each option holder's percentage in the same way they reduce the founders'. The value of the options can still rise if the round increases the company's valuation.