Serial Dilution

The dilution in welding terms is defined as the weight of the base metal melted divided by the total weight of the weld metal. For example, if we have a dilution of 0.40, the fraction of the weld metal that came from the consumable electrode is 0.60.

Trademark dilution refers to the unauthorized use of and/or application for a trademark that is likely to weaken the distinctive quality of or harm a famous mark. The question of whether a famous trademark is diluted is a separate question from whether the mark is infringed, i.e., whether the unauthorized use is likely to cause consumer confusion (though trademark owners often allege both dilution and infringement together when enforcing famous trademark rights). Dilution is sometimes divided into multiple types, the most common being blurring. Other types include tarnishment and, in the EU, free-riding.

Serial Dilution

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Unlike trademark infringement, trademark dilution does not necessarily involve the unauthorized use of a mark in connection with goods or services that are confusingly similar to those offered in connection with the famous mark. For example, the unauthorized use of FERRARI as a brand of harmonicas may not be trademark infringement, but it may be trademark dilution, even though harmonicas and luxury automobiles are so unrelated that consumers are unlikely to believe Ferrari harmonicas come from the famous automaker. Trademark dilution protects marks that are so well-known, highly reputable, or famous that jurisdictions have decided they deserve protection whether or not their unauthorized use is likely to cause consumer confusion.

Most countries recognize some form of trademark dilution, although the concept and associated requirements and penalties vary by jurisdiction. Jurisdictions that expressly recognize trademark dilution include the United States, the European Union, South Africa, India, and Japan, as well as several Central and South American countries. Others, such as Canada and Australia, have no explicit dilution law but provide similar protection under other trademark laws. Canada prohibits unauthorized use that deprecates the goodwill of a mark, and Australia defines trademark infringement to include the use of well-known trademarks that is likely to cause consumers to infer a connection between the owner of the mark and unrelated goods or services.

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.

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%.

This rolling dilution calculation is just an example. If you have diluted more than that, don't get upset. Most founders end up with less than 42% after rounds of financing and employee grants. The point of this exercise is not to lock down onto some magic formula. Every company will be different. It is simply to lay out how dilution works for everyone in the cap table.

Here is the bottom line. If you are the first shareholder, you will take the most dilution. The earlier you join and invest in the company, the more you will be diluted. Dilution is a fact of life as a shareholder in a startup. Even after the company becomes profitable and there is no more financing related dilution, you will get diluted by ongoing option pool refreshes and M&A activity.

When you are issued employee equity, be prepared for dilution. It is not a bad thing. It is a normal part of the value creation exercise that a startup is. But you need to understand it and be comfortable with it. I hope this post has helped with that.

When it is too good to be true, just have to walk away holding your nose tight.Those kinds of deals are made by fly by night operators.I wonder if Google founders ended up with a similar dilution path. If I am correct they got to hold on to 28% between the two of them.I also feel sometimes founders and other early employees hold out for more, and I think that is a greedy attitude as it is better to have a small share of a growing company than a large share of a stagnating company.

I have a much finer appreciation for the process, thanks Fred.This paints the picture for the info I was guessing at in an earlier comment last Monday. Curious if this dilution turns into down rounds for early employees if they can cash out or buy back in.

As echoed elsewhere in the comments dilution is not always bad. It is very tough, sometimes, to explain to founders that 30% of a bigger pie is better than 40% of a smaller pie. If each fund raise is accretive then the $ slice gets bigger as the % slice gets smaller. In a similar way I have seen companies not want to reverse-split stock as they feel that their employees would feel worse with fewer shares. Another example of where logic and emotion are in conflict.

Fred, this is a very nice piece and it has turn the light on on a very important issue. I bootstrapped my startup about 2yrs ago and we gained traction, this time around we want to scale so we approach an investor on convertible note funding (this is the best for them as they are yet to understand consumer internet business in my country, Nigeria) we about to close that deal now. But with our performance we are begining to get interest from VCs but we may not be able to close the deal for the next 2months (we just started talking). So, given that we need funding to scale, we want this loan badly so, getting this convertible note is inevitable for us. Going forward, if we get the funding, should we pay out the note from the fund or in another case if the investor now wish to convert before the due time, how best do we deal with the dilution.Also, our employees are more or less on a part-time bases, and we plan to give then options (since we aint paying them salary yet) how best do you deal with this kind of scenario, dilution, % etc?as an aside; disqus is hell when using opera mini on mobile, I found it very difficult to comment. always refreshing and losing already type comment. Guess you invested in the startup, you can tell them to look into it. tnx

Good, clear explanation of this. Perhaps this would be a worthy topic for a separate MBA Mondays post, but the continued dilution due to options grants after a company becomes profitable (and even after it goes public) can be a cause of concern for equity investors. If a company needs to raise capital to become profitable, dilution is a legitimate price to pay for that. But should dilution be necessary to attract and retain employees once a company is profitable?With public companies, at least, this can drift into an agency conflict where senior managers liberally award themselves options grants.

Btw, I am always surprised how tax insensitive founders and employees are. The time to prepare for the massive 50% tax bite (which matches your dilution analysis, and on which there is no return whatsoever) is at the get-go, even though there is more complicated structures and more difficult explanations to employees.

Phenotype: Pigment granules in the hair shaft are clumped and unevenly distributed, producing dilution of coat colors. For example, black pigment is diluted to gray and red is diluted to cream.

A mutation in Melanophilin (MLPH) causes clumping and uneven distribution of pigment granules in the hair shaft, producing dilution of all coat colors. Dilute is caused by the deletion of a single base (c.83delT) resulting in disruption of the MLPH protein product. Dilute is an an autosomal dominant trait, which means that two copies of the dilute allele are needed to produce the phenotype. Black pigment is diluted to gray ("blue" is the term used by cat breeders), and red is diluted to cream. The wild type allele is non-dilute. Some cat breeds are fixed for the wild type, such as Egyptian Mau and Singapura, while others are fixed for dilute, such as Chartreux, Korat, and Russian Blue. Most other breeds have both wild type and dilute alleles.

Keesing and colleagues (Keesing et al., 2006) reviewed the dilution effect hypothesis and outlined five hypothetical mechanisms through which changes in species richness could influence infection risk: reductions in encounters between host and parasite, reductions in transmission (following an encounter), increased host recovery from infection, increased mortality in infected hosts, and decreased density of susceptible hosts. The authors developed these mechanisms through careful examination of the parameters in standard infectious disease models, beginning with a directly transmitted microparasite and extending this approach to a vector-borne infection. Most of the empirical examples reviewed by the authors involve encounter reduction and susceptible host (or vector) regulation. Thus, changes in community richness tend to either reduce the availability of susceptible hosts (e.g. through interspecific competition) or reduce the likelihood that an infected host/vector encounters a susceptible host, independent of host density. Whether other mechanisms are less likely to cause a dilution effect or are simply understudied remains conjectural. Given that many of these mechanisms are difficult to differentiate from field data alone, it is also possible that field-observed correlations between species richness and disease risk represent the product of multiple, concurrently operating mechanisms. 006ab0faaa