As exciting as fundraising is for the financial benefits it brings to the table, fundraising decisions come with long-term implications, including share dilution, which is critical to think through before accepting any new funds. When you raise money at a startup your ownership percentage of the company goes down. As the founder of the company, your goal should be to have the value of the startup go up by enough that you own a smaller percentage of a much larger business and therefore your total personal value goes up.
With that being said, if you are a founder/shareholder of a promising startup trying to understand how you should plan the fundraising and the share dilution that comes with it, then you should probably continue reading this piece.
So, what exactly is Share Dilution?
Ownership in any company is capped at 100 percent. No matter how many capital increases/decreases, (reverse) stock-splits, share buy-backs, or other shenanigans happen, total ownership can never exceed 100 percent. This leads to the obvious conclusion that any addition of new (equity-) shareholders inevitably reduces (dilutes) the shareholding percentage of some (or all) of the existing shareholders.
This basic concept can be referred to as “ownership dilution”. Imagine a company with two founders with 50% ownership. They want to get their first investor on board. The investor will receive 20% participation in the company in return for a specific investment amount as well as other non-monetary support.
No matter how you structure this deal (e.g. issuance of new shares through capital increase, or transfer of existing shares via secondaries), the combined shareholding percentage of the two founders will need to decrease to 80 percent to make room for the investor. In other words, the addition of the new investor dilutes the founders’ ownership stake in the company.
What are the 2 most common causes of share dilution?
There are 2 main scenarios where equity dilution may happen for a startup:
- Fundraising rounds. When a startup raises equity from investors, it issues new shares to new investors in return for their investment. Startups can also issue convertible notes (or SAFE) which are a form of debt that can convert into equity at a given price. When they convert, startups need to issue new shares which dilute existing investors.
- Stock options pools. Startups often create a stock options pool for employees (ESOPs for Employee Stock Option Pools). These pools of options can be exercised at a later stage and convert into shares.
How does share dilution affect you as a shareholder?
One thing investors tend not to like about share dilution is that it also causes the dilution of earnings per share (EPS), which is a helpful metric in assessing a company’s profitability. In some cases, investors may be able to evaluate the impact of share dilution by looking at diluted earnings per share (diluted EPS), which calculates EPS assuming all convertible securities ultimately convert.
But when it comes to the effects of share dilution, we’re not just talking about pure earnings. In many cases, a large ownership stake in a company can come with dividends, voting rights, and other shareholder rights, which can be impacted by share dilution too. This is especially true for founders and early investors, who may see a large or majority stake in a company dwindle over time as their shares become more and more diluted.
With that said, share dilution does not necessarily have to be a bad thing for investors. As discussed above, share dilution does not just happen for no reason at all. If a company has a sound reason for issuing new shares and/or uses the money raised to meaningfully improve its operations, then everybody can eventually end up happy. After all, owning 10% of a The Cheesecake Factory sounds quite better than owning 20% of a cherry pie.
How can shareholders protect themselves from dilution?
Given everything we already discussed the logical follow-up question for the founders would be how to protect themselves from the negative effects of the share dilution.
Shareholders can be protected from dilution resulting in future rounds of financing or share issuances through anti-dilution provisions, also referred to as preemptive rights, which usually appear in the company’s term sheet or other contractual agreements. These provisions give existing shareholders various rights, including preemptive rights to buy their pro rata shares in a subsequent equity offering.
Part 2 coming up soon…
DISCLAIMER: The content of this article is solely for informational purposes and may not be construed as legal, tax, investment, financial, or other advice.