How Should You Think About Dilution?

 In Blog

Dilution is a tricky subject. First, it’s uncomfortable being diluted – giving up a significant part of what you’ve worked hard to create to someone else. It’s uncomfortable to have to “admit” that your organization is missing something and that thing you’re missing is so essential that you’re willing to give up a part of yourself to get it.

We’re used to things being additive. You meet someone, you fall in love, you get married – it’s 1+1=3. It’s not, you meet someone, you fall in love, you cut off your finger and give it to your fiance, and then you get married. That would be 1+1-a finger=3. It sounds much worse.

So, when you look to hire someone, or a group of someones, the idea that they want a part of you (a part of your company’s stock) in order to join feels awkward. So, when should you do it?

Here’s a simple equation that I live by. Ready? Hold on to your hat it’s a wang doodler… You do it when you absolutely have no choice and the value you’re getting is clearly (crystal clearly) worth more than the stock you have to hand over.

Let’s break that down. First, you do it when you have no choice. In other words, if there are several similar paths and one is more dilutive than the other, run from the one that’s more dilutive. Second, you do it when the value of what you’re getting is more than the value of what you’re giving. So, if you’re just starting a company or your existing company is not doing all that well, you should be far more willing to be diluted in order to gain outside talent. Giving away stock that is relatively worthless should never scare you. To the contrary, when your stock is worthless, you should give away tons of it in order to make it worth something.

But, when your business is doing well and you have something of value, you need to be extremely careful to hold on to it as you grow. Too often a misconception of the Silicon Valley mindset is that talent is priceless and you shouldn’t worry about being diluted to acquire it. In fact, the entire VC cap table is built around this concept. Do a financing round and the first thing you will hear is “We need to set aside 10% or 15% of the company for new hires.” And as you grow, every key hire thinks in terms of percentages. Need a CEO – that’s 5%. Need a COO – there’s another 3%. How about a CFO – 2%. And your senior tech guys – each one will want half a percent or more. The funny part is that if you followed the “industry norms” of what everyone should get, your early stage management team would consume 25% of the company.

Yet here’s the funny part; this equity typically vests over 3 or 4 years so as soon as your company hits its toddler years, you’ll need to do it all over again. Following this absurd paradigm, by the time your company is 10 years old, management would own the vast majority it.

And to make matters worse, the Valley “flavor of the month” seems to be centered around the idea of taking a group of people whose only connection is that they happen to work for the same failed start-up and packaging them together in what’s called a “talent acquisition”. It goes like this: Someone starts a company. They hire 5 or 10 or 20 people. They raise money from a bunch of Angel investors. The company totally fails. The Angels then package the people and sell them off as a group to recoup their investment. Don’t be confused if it sounds like a bizarre form of indentured servitude – it’s not. The people can leave anytime they want, which means you’re basically paying 10x or 100x what you would normally pay a recruiter just to save a few months.

Sorry for the tangent. Back to dilution.

Look, I recognize as much as anyone the insane value of smart people. I realize they don’t fall off trees and I also realize the enormous value they can create. Clearly I realize it which is why we haven’t lost a senior manager from our group of companies in the past decade. Not a single one. It’s like the show LOST around here – no one seems to ever leave the island.

But I also recognize that businesses are much more resilient then most of us think and they tend to go on even after talented people walk out the door. Often, other talented people take over. And if not, the organization seems to somehow rise to the occasion and manage its way through the loss. Rarely do you come across a situation where someone who was doing a fantastic job left and the company just seemed to crumble. So you have to put talent in perspective.

There’s a few other reasons to be careful about dilution. First, consider the cumulative effect of achievement; take into account that the sum of the parts makes the whole more valuable and yet most often you’re compensating the individual as if they alone were doing all of the work. Second, dilution is hard to contain. You give this person X, and that person Y, and someone else Z and when considered alone, each grant makes total sense and yet you turn around one day and you’ve given away 3 times more than you ever could have imagined. Third, for every person that gets too little there are 5 that get too much. It’s just impossible to have enough foresight to understand how the organization is going to evolve over time and compensate people accordingly. People change jobs, change responsibility, they grow, or they don’t. Some of your stars will become inconsequential and some of your no-names will becomes stars. That’s just how it goes.

So, what does this all mean? How should you think about dilution?

I think you need to find and recruit and pay up for great people. You need to recognize that without talent your organization can’t possibly reach its full potential. But you also need to be careful and manage dilution carefully.

Think of shares of stock as being identical to cash. Subscribe a value to your stock and in each instance when you’re ready to hand over some of your stock ask yourself this: “would I be willing to part with the cash instead of the stock?” If the answer is no, don’t do it, because in the end stock has a real value – just like cash.

Watch every share. Hold onto them tightly. Guard them as if they’re gold. And if your lucky, by the time you’ve recruited a world class team and gone through a Series A, B, C, D, E, and F, then maybe, just maybe, you’ll have a few shares left for yourself.

-Eric Lefkofsky

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