Allocating ownership this way rewards early-stage investors for making high-risk investments in developing companies, while later-stage investors receive lower returns for taking on less risk. Most investors do not disclose what ownership percentage they acquire in their investments, but a handful of investors have shed some light on the subject.

Fred Wilson, an established venture capital investor or VC , provides some general guidelines for entrepreneurs regarding how much ownership investors seek in the company at each stage of financing. As shown in the table above, Series A investors usually demand the highest percentage in the company. The Series A round often represents a much larger capital investment compared to prior fundraising efforts and a substantially higher risk than later funding rounds. VCs therefore require a higher stake in the company to compensate them for the high risk of the investment. Wilson has also provided some general estimates shown in the table below for the typical ownership structure in companies that undergo a late-stage exit, like an IPO.

While these estimates can be useful, remember that each company may have a different ownership structure depending on its financing choices. For example, if a company has an early-stage exit, the founders would probably have a significantly higher ownership than what Wilson suggests while investors would have a lower ownership percentage. Although founders often expect to retain control over their startup forever, the table above shows that outside investors usually own the majority of shares in a late-stage startup.

Founders lose much of their ownership because they are diluted with each round of financing. Founders should remember during early-stage funding that additional dilution will likely occur in the future.

Investors also receive pro-rata rights which allow them to participate in subsequent financing rounds to maintain their ownership percentages. Without these additional protections, founders often experience higher levels of dilution than investors. Most startups use computer spreadsheets or software programs to construct capitalization tables , which record the ownership percentage of each investor.

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In addition to shares controlled by founders and investors, the firm also records issuances of securities which may become stock in the future such as restricted stock units, warrants, and stock options. Cap tables are important tools for founders, current investors, and future investors to fully comprehend their current ownership position in the company and how different funding scenarios might impact their ownership.

Throughout the rest of this article, you will see cap tables used for illustrative purposes. The subsequent example provides an illustration of how dilution might occur in a Series A equity round. Consider a hypothetical company called Startup Incorporated Inc. The company has two founders each with 5 million shares , has granted , stock options to its current employees, and has authorized , additional stock options to be granted in the future. Startup Inc. Now imagine that Startup Inc. Investor 1 purchases 3 million shares and Investor 2 purchases 2 million shares.

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Observe how the ownership percentages changed following the Series A funding round. Given the capital structure after Series A funding, each founder only owns Each founder would still have Management and investors usually discuss the size of the option pool as part of their negotiations prior to finalizing a deal.

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The timing of when the startup creates the option pool determines which shareholders experience dilution. If the startup expands the stock option pool before the new funding round, only the past shareholders including founders will be diluted. If the startup expands the stock option pool after the new funding round, then all shareholders including the new investors will be diluted.

Since incoming investors typically have better negotiating leverage and they want to ensure that the pool will be expanded before committing their investment, startups usually must expand the stock option pool before closing the new funding round. Depending on the details of the stock option plan, the stock option pool can cause significant dilution to founders.

Allocating stock options for an employee stock option plan (ESOP)

Formulating a comprehensive stock-based compensation strategy is beyond the scope of this article, but the topic deserves the attention of founders, investors, and management. To better illustrate how the option pool affects company ownership, we will reconsider the Series A funding round for Startup Inc. The cap table below shows the initial ownership structure for Startup Inc. Dilution results in changes to factors such as share price, ownership percentage, earnings per share and company voting rights.

Determining the point at which employee stocks dilute the overall stock pool depends upon the type of employee stock in question. Dilution as a result of employee stocks may occur upon granting, exercising or vesting. Employers provide employees the opportunity to purchase company stock with stock options. When a company grants stock options, it reserves a certain number of stocks for a set period. Employees can purchase, or exercise, these stocks between vesting and expiration if they choose. Vesting constitutes the point at which an employee may purchase granted stock options.

Employee Stock Options Don't Work the Way Most People Think

Dilution with stock options occurs upon exercising because previous to exercising, no one owns these shares. Ownership and share value dynamics only change when new owners enter the fray. Restricted stocks constitute a form of bonus. When granting restricted stock, employers promise to provide a certain number of shares to an employee as a gift at a set future date. The delivery of the stock occurs at vesting. Unlike stock options, employees need not purchase restricted stocks.

Dilution occurs with restricted stocks upon granting. When employers grant restricted shares, those shares technically belong to the employee, even though employees can only access them upon vesting. Therefore, the employee owns these stocks, and becomes part owner of the company, upon granting, thus causing dilution.