Raising external capital can give an Australian business the runway to build product, hire key people and reach the next stage of growth. But every equity funding round changes who owns the company, who has voting power and how future value may be shared.
The challenge for founders is not simply to raise the highest possible amount. It is to raise enough capital, on terms that support the business, without giving away more ownership, control or flexibility than necessary. Understanding dilution before the term sheet arrives puts founders in a far stronger position.
What dilution means in a funding round
Dilution occurs when a company issues new shares and the existing shareholders own a smaller percentage of the company afterwards.
Importantly, dilution usually does not mean that founders have transferred or sold their existing shares. Instead, the company creates and issues additional shares to a new investor, employee or other participant. The total number of shares increases, so the percentage represented by each existing holding falls.
For example, imagine a founder holds all 100 shares in a company. The company issues 25 new shares to an investor. The founder still owns 100 shares, but now owns 100 out of 125 shares in total. Their ownership percentage has reduced, even though they have not personally sold any shares.
That reduction can be worthwhile if the funding enables the company to become more valuable. A smaller percentage of a much stronger business can be preferable to full ownership of a business that does not have the capital to execute its plan.
Still, percentage ownership matters. It can affect:
- voting rights and the ability to pass shareholder resolutions;
- board composition and practical influence over decisions;
- entitlement to dividends or sale proceeds;
- eligibility under shareholder agreements, employee incentive plans and investor rights;
- the founder’s position in later funding rounds; and
- the economics of a future sale, particularly where different share classes or investor preferences apply.
A funding round should therefore be assessed as a combined commercial, legal and tax decision, not merely as a cash injection.
Start with the cap table, not the valuation headline
A cap table, short for capitalisation table, is the working record of who owns shares, options, convertible instruments and other rights to acquire shares in the company.
Founders should keep a clean, current cap table from the earliest stages of the business. It should show issued shares by holder and class, as well as any options, warrants, convertible notes, SAFEs or similar instruments that may convert into equity later.
The central dilution calculation is straightforward:
Existing ownership percentage after the round = existing shares held ÷ total shares after the new issue
However, the practical analysis is more involved. A founder needs to understand not only the immediate share issue, but also what may happen on a fully diluted basis.
A fully diluted cap table assumes that all options and conversion rights that could become shares are exercised or converted. This provides a more realistic view of potential ownership after the funding round.
Before agreeing to a deal, founders should ask:
- How many shares are currently issued?
- Are there different classes of shares with different voting or economic rights?
- Are there outstanding options or rights that may convert into shares?
- Is there an employee share scheme pool already in place?
- Is the investor expecting the employee option pool to be increased before their investment?
- Will a convertible note or SAFE convert as part of the round?
- Will any investor receive rights that affect the economic value of ordinary shares?
- What does the cap table look like immediately after the round and after all potential securities convert?
A common trap is to focus only on the founder’s percentage immediately after the investor shares are issued. That can understate the real dilution if there is a new employee option pool, a conversion discount or another instrument that will result in future share issues.
The pre-money and post-money valuation language also needs careful attention. A pre-money valuation is the agreed value of the company before the new funds are invested. A post-money valuation includes the new investment. The distinction affects the percentage being issued to the investor.
Founders should not accept a valuation label at face value. Ask for the share-price calculation, the assumed number of shares on issue and the exact cap table used to calculate the investor’s ownership.
Raise for a defined milestone, not simply the longest possible runway
The amount raised is one of the biggest drivers of dilution. Raising more capital than the business can deploy effectively may result in unnecessary equity being issued. Raising too little can force another round before the company has improved its negotiating position.
The better question is: what value-creating milestone will this capital help the business reach?
Depending on the business, that milestone may include:
- completing a product version ready for commercial rollout;
- securing a defined level of recurring revenue;
- demonstrating product-market fit;
- obtaining a regulatory approval;
- building a repeatable sales process;
- reaching a production or inventory milestone; or
- recruiting capability that removes a major execution risk.
A clear use-of-funds plan helps founders decide how much capital is actually required. It also gives prospective investors confidence that the company has disciplined financial management.
The plan should connect funding to outcomes. Instead of saying the business needs money for “growth”, identify the operational activities, expected timeframe, key assumptions and decision points. This makes it easier to assess whether debt, grants, customer prepayments, strategic partnerships or staged equity funding could meet part of the need.
For some businesses, non-dilutive or less-dilutive funding may be relevant. Options can include revenue-based funding, equipment finance, working capital facilities, commercial partnerships, research and development incentives where eligibility requirements are met, grants, or customer deposits. Each option has its own cost, eligibility criteria, risk and cash flow impact, so it should be assessed carefully rather than treated as a substitute for equity in every situation.
Equity is often appropriate for a business with uncertain early cash flows, a long development cycle or an ambitious growth plan. But it should be raised with a clear understanding of what the business is giving up in return.
Negotiate the terms that sit behind the ownership percentage
Two funding rounds can produce the same headline dilution but leave founders in very different positions.
The price per share and ownership percentage matter, but the investor’s rights may matter just as much. These rights are commonly addressed in a term sheet, constitution, shareholders agreement, subscription agreement or related documents.
Areas that founders should understand before signing include the following.
Board and governance rights
An investor may seek a board seat, observer rights or consent rights over major business decisions. These can be reasonable where an investor is contributing significant capital and expertise, but founders should understand how they operate in practice.
Consent rights may cover matters such as issuing further shares, changing the company’s constitution, taking on substantial debt, selling key assets, changing the nature of the business or approving a sale. The scope should be proportionate and should not make ordinary commercial decisions unnecessarily difficult.
Share classes and economic rights
Not all shares necessarily have identical rights. A company can issue different share classes, each with its own rights or restrictions. ASIC notes that companies can decide the rules for their share classes, including benefits and limitations associated with them.
This means founders should understand whether investors are receiving ordinary shares, preference shares or another class of security. Particular attention should be given to rights that apply on a sale, winding up, dividend payment or future share issue.
A liquidation preference, for example, can affect how sale proceeds are distributed before ordinary shareholders receive proceeds. It is not enough to look at an investor’s percentage ownership if the investor has preferential economic rights.
Future funding and anti-dilution arrangements
Investors may request rights to participate in future share issues so they can maintain their percentage holding. Such rights can be commercially understandable, but founders should consider the impact on future fundraising and whether the process will remain workable.
Anti-dilution provisions also deserve careful legal and financial review. Their impact can vary significantly depending on the drafting and the circumstances of a later down round.
Founder vesting and leaver provisions
Investors may ask founders to have shares subject to vesting, or to transfer shares in specified circumstances if they leave the business. These clauses can be important to investors because the founders’ continued involvement is often central to the investment case.
However, the terms should be clear and balanced. Founders should understand what happens if they resign, are removed, become unable to work, have a dispute with the board or are terminated without cause.
Transfer restrictions and exit provisions
Shareholder agreements often contain restrictions on selling or transferring shares. They may also include drag-along and tag-along provisions, rights of first refusal and compulsory transfer provisions.
These clauses can help create an orderly ownership structure, but they can also limit a founder’s flexibility. The commercial effect should be explained in plain English before documents are signed.
Plan employee equity before it becomes an urgent problem
Hiring and retaining talented employees often requires more than salary, particularly in a growing company. An employee share scheme can help align employees with the long-term success of the business, but it can also create material dilution if it is not planned properly.
An employee share scheme may involve shares, options or rights to acquire shares. Australian tax law contains specific rules for employee share schemes, and the tax outcome for employees and the company depends on the plan design and the facts.
Some start-up employee share schemes may qualify for concessional treatment if the relevant legislative conditions are satisfied. The rules are detailed and can turn on matters such as the company, employee, scheme terms, valuation and holding conditions. Founders should obtain advice before assuming a plan is eligible for any concession.
From a dilution perspective, the key issue is when the option pool is created and who bears its impact.
Investors may ask for an employee pool to be established before the funding round. If that occurs, the existing shareholders may bear the dilution from the pool before the investor comes onto the cap table. That is not always inappropriate, especially if the business genuinely needs to recruit, but it should be transparent and included in the funding model.
A sensible approach is to estimate the roles the business expects to fill before the next funding milestone, then design an equity plan that supports those hires without reserving an unnecessarily large portion of the company.
Consider Australian compliance and tax consequences early
A funding round requires more than an agreed valuation and signed term sheet. Company records, share issue documents and ASIC notifications need to be handled properly.
ASIC states that a share issue occurs when a company creates and allocates shares, and that companies must maintain details of issued shares on their share register. ASIC also requires notification of a share issue within 28 days after the issue.
A proprietary company also needs to remain mindful of the legal limits and fundraising rules that apply to its structure. The Corporations Act limits a proprietary company to no more than 50 non-employee shareholders, and fundraising by proprietary companies is subject to restrictions, including disclosure requirements in relevant circumstances.
Tax should be considered before, rather than after, the transaction documents are finalised. Relevant issues may include:
- the tax consequences of issuing or transferring shares;
- the treatment of founder shares and investor shares;
- employee share scheme taxation and reporting;
- the valuation methodology used for shares or options;
- the effect of a funding round on access to tax concessions or incentives;
- the use of trusts, companies or superannuation entities in the ownership structure; and
- the tax implications of a future exit.
For example, some investors may assess whether a company can qualify as an early-stage innovation company for investor tax incentive purposes. That is a separate eligibility analysis and should not be assumed merely because a business is a start-up. The ATO’s guidance makes clear that the rules depend on both company and investor circumstances, including the nature of newly issued shares and ownership outcomes.
A practical approach to reducing avoidable dilution
There is no universal “right” amount of dilution. A founder who retains a larger percentage of an underfunded business may be worse off than a founder who accepts meaningful dilution in exchange for the capital, capability and investor support needed to build a valuable company.
The aim is to avoid avoidable dilution. In practice, that means preparing before negotiations begin.
A useful pre-raise process is:
Build an accurate cap table. Include issued shares, option pools, convertible instruments and likely conversion outcomes.
Set a funding target linked to a milestone. Identify what the capital will achieve and how that should improve the company’s next valuation or financing position.
Model multiple scenarios. Compare different investment amounts, valuations, option-pool sizes and future rounds.
Assess investor fit as well as price. Consider sector knowledge, networks, follow-on capacity, governance expectations and alignment with the founders’ plans.
Review the full term sheet. Do not focus solely on valuation or the investor’s percentage. Understand control rights, preferences, vesting and future funding provisions.
Coordinate legal, tax and accounting advice. The cap table, company records, valuation support, tax treatment and transaction documents need to tell a consistent story.
Consider a growing software business owned by two founders. It receives an offer that appears attractive because the proposed valuation is high. However, the investor also requires a sizeable employee option pool to be created before completion, a board seat, broad consent rights and preferential sale proceeds. After modelling the fully diluted cap table and likely exit outcomes, the founders may find that a slightly lower valuation with simpler terms creates a better long-term result.
That is why funding decisions should be modelled rather than negotiated from headline terms alone.
Keep ownership decisions aligned with the business plan
Dilution is a normal part of equity fundraising, not necessarily a sign that founders have made a poor deal. The important issue is whether the capital, investor relationship and legal terms collectively help the company move toward its next meaningful milestone.
Founders who maintain clean records, understand their cap table, plan employee equity early and model several funding scenarios are better placed to negotiate with confidence.
This article is general information only and is not personal financial or tax advice. Before issuing shares, implementing an employee equity plan or accepting investment terms, speak with a registered tax agent, accountant and appropriately qualified legal adviser about your circumstances. can help you assess the accounting, tax and financial implications of a proposed funding round and prepare for the decisions ahead.