Dilution is when a company issues shares that cause a reduction in the ownership percentage of existing stockholders.

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Stock dilution may also occur when holders of stock options, such as employees or holders of other optionable securities, exercise the options. Each share becomes less valuable if the stockholder’s shares increase in number.

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This regularly happens when companies need to raise outside capital like venture capital.

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Takeaways:

  • Dilution refers to the diminution of shareholders’ equity positions due to the creation or issuance of new shares.
  • Also, dilution can reduce a company’s earnings-per-share (EPS), negatively impacting share prices.
  • Although existing shareholders may be disadvantaged, a company can dilute when it raises more equity capital.

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What is Equity Dilution?

Equity dilution is when the issuance or purchase of new shares diminishes the founder’s stake in the company. This can often occur following an investment. A founder might acquire 20% of a SaaS startup’s shares in exchange for angel investment.

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Founders often offer equity or shares to employees to fund fundraising efforts. Then they move on to make an initial public offering (IPO) or to attract other investors by sharing a portion of the company.

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Because most early-stage founders donโ€™t have much money to start, equity dilution can be pretty standard in the early-stage startup industry.

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After they have validated the product and are ready for it to go to market, they will need cash to scale up and grow. This can be done by giving away equity in the company for investment.

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Equity dilution, also known as share dilution, is the reduction in the ownership percentage of existing shareholders after new shares are issued and reserved. It happens after certain events, such as a fundraiser or the creation of an employee option pool.

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Let’s take, for example, that you are the sole owner of your business and own 10,000 shares. You are happy with the company’s performance and decide to create a 1,000-share employee option pool for future employees. In return for capital, you give 2,000 shares to an investor. You now have 13,000 shares of company stock on a fully diluted basis. And you own 77% instead of 100% of your company (10000/13,000).

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The share dilution process can affect both your financial stake and the amount of control you have.

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Understanding Dilution

Dilution means that the equity “cake” is cut into smaller pieces. Each piece will be smaller, but there will be more. You will still receive your slice of the cake, but it will be smaller than you expected. This is sometimes not desirable.

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Dilution has a significant impact on equity ownership positions. However, it also affects earnings per share (EPS or net income divided by the float), which can depress stock prices. Many public companies provide estimates of non-diluted and dilute EPS. If new shares are issued, this is a “what-if scenario” for new investors. The assumption that potentially dilutive securities are already converted to outstanding shares dilutes EPS.

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When a company raises more equity capital, share dilution can occur. New shares are issued to investors. This method of raising capital can have potential upsides. The company may increase its profitability, growth prospects, and stock value by selling additional shares.

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Existing shareholders are not likely to view share dilution favorably. Companies sometimes start share purchase programs to reduce the impact of dilution. Stock splits don’t cause dilution. Current investors get additional shares when a company shares its stock. However, the price of the shares will be adjusted to reflect the change. This keeps their share ownership static.

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A general example of dilution

Let’s say that 100 shareholders have received 100 shares from a company. Each shareholder has 1% ownership of the company.

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Each shareholder can only own 0.5% of the company if the secondary offering is made and 100 shares are issued to additional shareholders. A smaller ownership percentage also diminishes each investor’s voting power.

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A real-world example of dilution

Public companies often announce their intention to issue new shares and dilute their existing equity pool long before they do. Investors, old and new, can plan accordingly.

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MGT Capital, for example, filed a proxy statement on August 8, 2016, that detailed a plan to grant stock options to John McAfee, the newly appointed CEO. The statement also provided information about recent acquisitions of companies, which were made with stock and cash.

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The executive stock option plan and the acquisitions will dilute the current pool of shares. The proxy statement also included a proposal to issue newly authorized shares. This suggests that the company is expecting more dilution in the near term.

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Dilution protection

Dilution is a common tactic for shareholders to resist as it devalues existing equity.

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Dilution protection is a contractual provision that restricts or prohibits an investor from having their ownership stake in a company reduced in subsequent future rounds. If the actions taken by the company reduce the investor’s claim on the assets, the dilution protection function kicks in.

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If an investor has a 20% stake and the company plans to raise additional more capital, it must offer the investor discounted shares to make up the difference. Venture capital funding agreements generally include dilution protection provisions. Sometimes, “anti-dilution” protection is used to refer to dilution.

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An anti-dilution clause is the same as an option or convertible stock. It is also known by the “anti-dilution” clause. This clause protects investors from equity dilution because the stock is issued at a lower price than originally purchased. These are common for convertible preferred stock, which is a popular form of venture capital investment.

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SAFEs, priced rounds, and equity dilution

A SAFE (Simple Arrangement for Future Equity) allows investors to invest in obtaining future shares of stock in your business. Although SAFEs are a great way to raise funds for a young company, they can also prove dilutive.

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What is equity dilution, and how does it work for raising a SAFE

SAFEs delay equity dilution until the subsequently qualified financing (usually your Series seed or Series A). SAFE holders receive shares in future funding rounds, often at a discount, in return for investing in your company early in its development. Ownership percentages will not be calculated until a new company valuation is made.

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You must know three main factors influencing SAFE dilution: the SAFE and the valuation cap.

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Equity dilution and priced rounds

Raising a priced round takes longer and is more complex than raising a SAFE. However, equity dilution can be calculated much easier. A priced round is where investors pay a fixed amount for some shares in exchange for the company’s valuation.

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Dilution may occur when you issue new investor shares or during priced equity rounds. When you raise a price round, these three factors can dilute equity: your option pool, the type of valuation, and convertible instruments.

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Pre-money vs. post-money valuation

The amount of the new investment can be affected by whether you have raised money in a price round based on pre-money valuation or after-money valuations.

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Let’s say your investor offers you $1 million in exchange for a $4 million valuation. If the pre-money value of $4 million is what you have, then that would mean that you own 80% after the investment. If you invest $4 million, however, 75% of your company will be your post-money value.

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Although a difference of 5% may seem small, it can result in millions of dollars of changed outcomes.

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Convertible instruments issued before your round

If you have raised money through SAFEs or other convertible instruments, your price round is when all of these convert to equity.

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It’s easy for investors to overlook early investors when you raise a high-priced round. When determining how much money you would like to raise and how much your company can afford to sell, you should factor in all the SAFE holders you owe (including early investors). This will help you to see equity dilution more holistically.

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Your option pool

You could also accidentally be subject to too much equity dilution during a priced round by forming a more significant option pool that you do not need. Option pools are shares that you create and reserve for future employees. It would be best if you remember that you are creating new shares and not taking from your existing shares. Option pools can dilute your ownership.

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Investors may ask you to create an options pool before you issue your shares. This will ensure that only the previous shareholders are diluted. If you are the sole shareholder, your ownership will be diluted. They may also push you to create more options than you need to avoid increasing your ownership and diluting it in the future.

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Before setting up an employee option pool, plan your next hiring strategy and the number of shares, you expect to give those employees.

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How to reduce share dilution

Every decision you make when fundraising can impact the amount of raising money you end up with and how much your company is worth.

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Although many of the things mentioned above are inevitable, some strategies can be used to reduce dilution.

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Don’t invest more money than you need to reach the next stage of your company.

The most dilutive money is the raise money you borrow early in your company’s life.

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Early investors receive equity when your company’s value is lower, so each dollar they invest in your company buys a larger share. This doesn’t mean you shouldn’t underestimate the amount of capital you need. Raising additional seed capital can be difficult, so make sure you forecast and target an amount that will get you to your next stage.

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Do not create more options than you need.

Investors might ask you to give more than you need. However, if you have a hiring plan, you can show how you arrived at your ideal pool size. This may be helpful in negotiations.

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Don’t rush.

Before signing any term sheets or SAFE, read the terms and conditions. Your decisions now will have lasting ramifications.

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Bottom line

Many of the suggestions we have discussed boil down to this: Do your best to understand what is going on, understand contract terms, and understand math.

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Once you’ve done all your homework, move quickly. Do not waste your time optimizing for one percent more here or a few thousand more. You have a startup to run.

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It is more important to get the right people together in the early stages and bring in smart money quickly and without much friction.

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To learn more about other terms commonly used in venture capital,ย check out our complete VC Glossary.

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