What is share dilution and how to calculate it?
What is dilution?
Equity dilution happens when a company issues new shares, causing the percentage of ownership for existing shareholders to decrease. For example, a founder who initially owns 100% of the company will see their ownership percentage drop each time more shares are issued, such as when raising money, exercising employee stock options, converting SAFEs or convertible notes. This is why it's often called "founder dilution." It's also known as stock dilution, share dilution, or startup dilution.
How dilution works?
To understand how dilution works in practice, let’s look at this example.
- Before dilution: The founder owned 100 shares, which is 100% of the company.
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After dilution: The founder's share amount did not change, it is still 100 shares, but the ownership percentage decreased to 80%, and it is because new shares in amount of 25 were issued to new investor and now total amount of shares is 125 shares.
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the founders dilution is now calculated by founders total amount of shares 100 divided by new total amount of company shares which is now 125.
Formula for share dilution -
new investors ownership percentage of new shares 25 is calculated same way by 25 shares divided with total amount of shares of 125.
Formula for share dilution.
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the founders dilution is now calculated by founders total amount of shares 100 divided by new total amount of company shares which is now 125.
This visual helps illustrate how dilution works in terms of ownership percentage.
Why is it important?
Dilution affects how much of the company founders own. As more shares are issued, founders ownership percentage decreases, which can reduce founders control over the company’s decisions. For founders, significant dilution can lead to losing majority control.
What are some common sources of equity dilution?
There are three common scenarios when shares are issued:
- Raising Capital: When you raise capital, you issue shares in exchange for equity. This is the most typical scenario, where ownership is given away in return for investment.
- Stock Options or Warrants: Stock options and warrants typically are issued to new hires and allow them to potentially join your company's ownership structure in the future, but they don't immediately result in the issuance of shares. These securities provide the right to purchase shares at a later date, usually under specific conditions.
- Convertible Debt: In this situation, debt holders have the option to convert their debt into shares, typically during a funding round or upon an exit event. This conversion results in dilution for the existing shareholders.
While there are other instances when a company might issue shares and experience dilution, these are the primary ones.
What anti-dilution measures should founders be aware of for investors?
Anti-dilution protection is a mechanism that helps protect early investors when a company issues new shares at a lower price than what those investors originally paid. This can happen in future fundraising rounds, and without protection, the value of early investors' shares would decrease, diluting their ownership in the company.
There are two common types of anti-dilution provisions:
Understanding these provisions is crucial for startup founders when negotiating with investors, as they can significantly affect the company's ownership and control during future funding rounds.
Strategies for founders when negotiating anti-dilution clauses.
For startup founders, the potential dilution and loss of control associated with a full ratchet anti-dilution provision can be challenging. Here are some strategies to consider when negotiating these terms:
- Request a Valuation Floor or Cap: Set a limit on how much the conversion price can be adjusted downward. This protects against excessive dilution by ensuring it doesn't drop below a certain level.
- Negotiate a Time Limit: Restrict the full ratchet to apply only during the early investment rounds. After a certain period or round, the provision could transition to a less stringent weighted average adjustment.
- Seek Exceptions for Specific Financing Events: Exclude certain events, such as an IPO or a secondary offering, from triggering the ratchet. This prevents unnecessary dilution in cases where a lower valuation is required for strategic reasons.
- Limit Triggering Events: Specify that the ratchet only applies to particular types of financing events, excluding scenarios like non-cash or non-equity transactions. This narrows the circumstances under which the ratchet is activated.
- Negotiate Redemption Rights or Shareholder Vote: Secure the right to redeem shares or remove the full ratchet after a certain period through a shareholder vote. This provides an exit strategy if the full ratchet becomes too restrictive.
- Require Investor Consent for Activation: Instead of making the ratchet automatic, investors must consent to trigger it. This gives founders more control over when and how the ratchet is applied.
TL;DR
Share dilution occurs when a company issues new shares, reducing existing shareholders' ownership percentages. It's significant because it can decrease founders' control over the company.
Common sources for dilutions include raising capital, stock options, and convertible debt. Anti-dilution measures, like full ratchet and weighted average provisions, protect early investors but can further dilute founders' shares. Founders should negotiate these clauses carefully, considering strategies like setting valuation floors and time limits and requiring investor consent to mitigate potential negative impacts.
Whenever you're considering fundraising, creating option pools or issuing convertible instruments regardless of the method, it's important to first model the impact of dilution. Scenario modelling helps you visualise how different financial instruments will affect your ownership and the future of your company.
