How Funding Decisions Influence Founder Ownership

Forbes

06-05-2025

Meenal Aggarwal is the founder of Groots Valuation with expertise in valuing stocks, intangible assets and complex financial instruments.
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Early-stage privately held companies often need funding to grow. Growth requires money, and startups use various financial tools to raise funds. While raising more money can fuel growth, it may also reduce the founder's equity ownership and gradually shift control to investors. Similarly, raising funds at a higher valuation can minimize dilution but may create pressure to meet heightened expectations.
Given this, it's important for founders to carefully select financial tools to avoid surprises like equity dilution and ensure the chosen option aligns with their goals and the company's objectives. My company conducts private company valuations, which has given me deep insights into the intricacies of these processes. We have worked closely with numerous founders, assisting them in valuing their equity, convertible debt, warrants and other financial derivatives. Time and again, I have observed that founders are often surprised when we account for the full impact of these tools on their stock price. Understanding different financial tools can help founders in their funding decisions.
Common Financing Tools
Simple And Convertible Debt
Founders can raise funds either through debt or equity. Generally, simple debt does not dilute founder equity. In this context, "simple debt" refers to a straightforward loan that is repaid in cash, along with any agreed-upon interest, by a specified maturity date. Unlike convertible debt, this type of debt cannot be converted into equity, remains solely a financial obligation, and therefore does not lead to dilution.
Convertible debt is a loan that can either be repaid or converted into equity. Conversion often happens during major events, like equity financing, a change of control or at the choice of the holder. If no event occurs, the company repays the loan.
Common And Preferred Stock
Common equity tools generally include issuing common stock or preferred stock. Common stock represents ownership in a company and typically comes with voting rights, allowing shareholders to influence corporate decisions. Companies can issue common stock shares directly to investors. This process often involves creating new shares for investors, which can dilute the ownership percentage of existing shareholders.
Preferred stock, on the other hand, generally doesn't carry voting rights but offers priority in dividend payments and claims on assets in the event of liquidation. Like common stock, issuing preferred stock can also lead to dilution. In my experience, venture capital or private equity firms typically invest in these shares depending on the company's stage.
Founders commonly use terms like "pre-money valuation" and "post-money valuation," which typically assume equal value for preferred and common shares. However, their values can vary. For example, before an initial public offering, when preferred shares are expected to convert into common shares, their values might equalize. Conversely, during a wind-down, the preferred stock might hold greater value due to its priority in receiving proceeds.
Secondaries And SAFEs
Secondary transactions are another common tool. This refers to when founders or existing shareholders sell their shares to investors rather than creating new ones.
Alternatively, a simple agreement for future equity, known as a "SAFE," is a promise to issue shares upon a future event, such as the next equity financing round. Shares are typically issued at a price that reflects either a discount to the new round's price or a pre-determined valuation cap.
How Different Tools Impact Dilution
The financial tools you choose significantly impact the dilution of your equity, the valuation of your shares and the decision making power of investors.
We can illustrate how the tools described above may impact dilution with an example. Let's say a company called ABC has a single founder holding 1 million shares, each valued at $1. Before raising funds, the founder owns 100% of the company's equity. ABC plans to raise $100,000 from investors. Here's how the founder's equity could change based on the chosen tool and its terms from the current 100%:
• Common Stock (Primary Transaction): Issuing common stock at $1 per share results in 100,000 new shares for raising $100,000. The founder's equity decreases from 100% to about 91% (1 million founder shares divided by 1.1 million total shares).
• Common Stock (Secondary Transaction): If the founder sells 100,000 existing shares to investors, the founder retains 90% equity (900,000 founder shares divided by 1 million total shares). Total shares do not change in secondary transactions, as the founder sells their own shares.
• Preferred Stock: Let's say the preferred stock is issued at $2 per share, and 50,000 shares will be issued to raise the targeted $100,000. Assuming one preferred stock converts to one common stock, the founder retains 95% equity (1 million founder shares divided by 1.05 million total shares).
• SAFE: Founder dilution occurs at a future event (e.g., equity financing). The extent of dilution depends on the SAFE's terms, such as valuation caps and discounts. The type of SAFE (pre-money or post-money) also plays a role in determining dilution.
• Convertible Debt: Similarly, founder dilution happens when debt converts into equity. The extent depends on the terms of the note, such as the conversion price.
Lessons For Founders
To determine which option is best for you and your business, ask yourself a few key questions: What funding options are available to you? How much funding do you need to raise immediately to achieve the company's objectives and ensure the business remains operational? How much control are you willing to relinquish? What percentage of equity dilution are you prepared to accept? Would it be more advantageous to dilute equity now or at a later stage? Once you've thoughtfully navigated these questions, you can select the tool that best suits your needs.
Selecting the right financial tool is a critical decision for founders of early-stage companies. Each option carries unique implications for equity dilution, valuation and future growth. By thoroughly evaluating these tools and aligning them with both personal and organizational goals, founders can raise the funds they need while preserving their equity. Thoughtful planning today ensures a stronger foundation for tomorrow's success.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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