Sources of Equity Dilution

an illustration to accompany the Shareworks by Morgan Stanley Equity Dilution Guide

Stock dilution, by definition, is a reduction in the percentage ownership held by the existing shareholders of a company when new shares are issued. As we noted in the earlier sections of this guide, dilution can happen immediately as a result of the issuance of new shares during a fundraising round, or it can happen when dilutive securities like stock options or convertible debt are converted into common stock. Whether dilution is “bad” or “good” for the shareholder isn’t black and white. In some cases, it may affect the shareholder negatively, in others it may be neutral or actually positive. It simply depends on the context and unique situation. 

Below, we’ll dive into the three most common types of dilution of shares:

Three Common Sources of Equity Dilution

  1. Restricted Stock and Stock Option Dilution

If employees are awarded restricted stock units (RSUs) as part of their equity compensation, the employer has effectively promised to provide a specific number of shares to an employee at a set vesting data in the future. When these shares vest, the employee becomes a part owner of the company. This dilutes the percentage ownership held by other shareholders. Another simplified way of thinking of it is that more people have smaller pieces of the same size pie.

  1. Issuance or conversion of convertible bonds, preferred shares, or warrants into stock

When convertible bondholders convert their bonds into stock at the issuing company, the stocks they receive are newly issued securities, which can dilute the ownership stake of previous investors. Without the proper protections in place, it’s likely that convertible bonds will dilute the ownership of current shareholders.

  1. Primary market offering

When a corporation sells stock shares to the public for the first time in an initial public offering (IPO) dilution can take place. However, whether dilution occurs depends on whether the newly offered shares are net-new or existing shares that were privately owned by company employees or investors.  When we think of dilution, any easy what to illustrate the idea is to think of a pie. The more shares you own, the bigger slice of the corporate pie you have. When money is raised by a public offering, earnings must be divided up across a larger number of shares. This, therefore, reduces each share’s individual value. In the end, more people own smaller pieces of the same sized pie.

Real World Dilution Statistics:  Equity Dilution Norms and Benchmarks

You may be looking for a way to benchmark where your company sits when it comes to equity dilution or learn about how much other companies typically set aside for options. When your goal is to make the right decisions for your company, it can be helpful to have context into what other companies are doing and what the trends are across the industry landscape. Below, we provide selected excerpts from the recently published Capshare (now part of Shareworks) Private Company Equity Statistics report built from real data from 10,000+ cap tables. Although the preview in this article only scratches the surface in terms of the wealth of information in the full report, you should be able to walk away with an understanding of employee vs. investor equity by stage, employee dilution by stage, and the median dilution rate by company stage. 

Employee vs. Investor Equity by Stage

An Image of employee equity ownership by stage from the 2018 private company equity report by CapShare

FOR ILLUSTRATIVE PURPOSES

According to the report, employees typically retain a majority stake in startups until somewhere around the Series B stage. The employee stake also includes options and other derivatives.  In some cases, options aren’t counted as “real” stock for corporate votes. In other cases, a company’s board may have more control of the company than the shareholders themselves. This particular equity statistics report found that it’s not uncommon for founders as a group to own less than 35% of their company at exit.

Non-Preferred Stock Ownership Percentage by Stage

An illustration of employee equity by stage from the private company equity statistics report from 2018

FOR ILLUSTRATIVE PURPOSES

Based on the report, executives typically give up meaningful but decreasing amounts of equity at each new fundraising stage.

Typical Equity Dilution Rates

An illustration of median employee equity in percentage points from the 2018

FOR ILLUSTRATIVE PURPOSES

Based on the findings of the equity statistics report, executives typically experience between 14-25% dilution regardless of fundraising stage. It should be noticed that dilution appears to be less dramatic at both the earliest and latest stages in a company’s life. Dilution tends to peak in Series A and Series B.

Some Final Thoughts

Knowing what equity dilution is, how to model it, and how to manage it are helpful skills for any private company CFO or founder to have. We hope that, now that you’ve read through the entire equity dilution guide, you’ve gained a strong understanding of stock dilution and how it can potentially affect founders. If you want to revisit an earlier part of the guide, you can head over to the guide home page to visit parts one through three.

Note: All benchmark data contained in this blog originated from the Capshare (now Shareworks Startup Edition) Equity Report. The report contains a statistical analysis of startup equity, including mean and median data, based on our experience of working with 5,000+ private companies. 

If you would like a personal demo of Shareworks Startup Edition to see how our platform can help you calculate dilution and run powerful scenarios, get in touch with us to request a demo.

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How to Calculate Equity Dilution: Determining Ownership Stake Over Time
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