Fred Wilson wrote an insightful posting about equity dilution here. There is also a Google doc spreadsheet to illustrate the example below.
The typical dilution path for founders and other holders of employee equity goes like this:
1) Founders start company and own 100% of the business in founders stock
2) Founders issue 5-10% of the company to the early employees they hire. This can be done in options but is often done in the form of restricted stock. Sometimes they even use “founders stock” for these hires. Let’s use 7.5% for our rolling dilution calculation. At this point the founders own 92.5% of the company and the employees own 7.5%.
3) A seed/angel round is done. These early investors acquire 5-20% of the business in return for supplying seed capital. Let’ use 10% for our rolling dilution calcuation. Now the founders own 83.25% of the company (92.5% times 90%), the employees own 6.75% (7.5% times 90%), and the investors own 10%.
4) A venture round is done. The VCs negotiate for 20% of the company and require an option pool of 10% after the investment be established and put into the “pre money valuation”. That means the dilution from the option pool is taken before the VC investment. There are two diluting events going on here. Let’s walk through them both.
When the 10% option pool is set up, everyone is diluted 12.5% because the option pool has to be 10% after the investment so it is 12.5% before the investment. So the founders now own 72.8% (83.25% times 87.5%), the seed investors own 8.75% (10% times 87.5%), and the employees now own 18.4% (6.8% times 87.5% plus 12.5%).
When the VC investment closes, everyone is diluted 20%. So the founders now own 58.3% (72.8% times 80%), the seed investors own 7% (8.75% times 80%), the VCs own 20%, and the employees own 14.7% (18.4% times 80%). Of that 14.7%, the new pool represents 10%.
5) Another venture round is done with an option pool refresh to keep the option pool at 10%. See the spreadsheet below to see how the dilution works in this round (and all previous rounds). By the time that the second VC round is done, the founders have been diluted from 100% to 42.1%, the early employees have been diluted from 7.5% to 3.4%, and the seed investors have been diluted from 10% to 5.1%.