Equity dilution is one of the most important topics for any startup executive.
Paul Maeder at Highland Capital Partners often speaks of Christopher Columbus’ voyage as the first great venture capital deal. The parallels are uncanny. One of the funniest aspects of the deal relates loosely to the concept of equity dilution.
The Spanish crown initially promised Columbus 10% of all revenue from any lands he discovered into perpetuity. So it was like they gave him a 10% stake on the cap table.
Could you imagine if your stake in your startup included the right to 10% of all revenues from North and South America forever? Talk about an awesome venture return!
Columbus negotiated this ownership after an initial refusal from his backers. According to Thomas C. Tirado, a History Professor at Millersville University:
His request for payment (one-tenth of all riches from the Indies and the rank of Admiral of the Ocean, Viceroy and Governor of the Indies) caused the sovereigns to flatly refuse the project. Tradition relates that as Columbus rode away on his mule, Ferdinand’s treasurer, Luis de Santángel, a member of a prominent family…, interceded on his behalf. Arguing that the investment was small considering the potential reward, Santángel was able to convince the King and Queen to reverse their decision. A court official was dispatched on horseback to bring him back. After several more weeks of negotiating a contract, Columbus left for Palos de la Frontera, in April, 1492, and his rendezvous with history.
In a show of bad faith that probably still gives investors a bad name, the Spanish crown ultimately reneged:
Columbus was later arrested in 1500 and dismissed from his posts. He and his sons, Diego and Fernando, then conducted a lengthy series of court cases against the Castilian crown, known as the pleitos colombinos, alleging that the Crown had illegally reneged on its contractual obligations to Columbus and his heirs. The Columbus family had some success in their first litigation, as a judgment of 1511 confirmed Diego’s position as Viceroy, but reduced his powers. Diego resumed litigation in 1512, which lasted until 1536, and further disputes continued until 1790.
So how does this relate to dilution in startups?
Dilution in startups is the decrease in ownership for existing shareholders that occurs when a company issues new shares.
So dilution decreases your ownership stake in your startup. But many things other than issuing new stock can also decrease a shareholder’s economic ownership. As Columbus discovered, sometimes investors have rights that can seriously decrease the benefit of ownership.
In this article, we’ll cover the basics but also some advanced concepts. Feel free to skip to the sections that apply to you:
- Definition of equity dilution
- The equity equation: Why dilute?
- Sources of dilution
- Equity dilution calculator
- Waterfall analysis and dilution
- Dilution norms and benchmarks from Shareworks Startup Edition's Equity Report
Dilution is really important for private companies and startups. As Fred Wilson has said:
This is a subject near and dear to entrepreneurs, maybe the dearest subject of them all. Founders start out with 100% of the company and every time they raise capital and/or issue stock and options to their management team, that number goes down.
Back in 2009, Fred and Sim Simeonov tried to get some real-world statistics on typical dilution rates but couldn’t find the data.
We’ve got some good news. At the end of this article, we provide dilution benchmark data for private companies at any stage.
Definition of Equity Dilution (Stock Dilution)
If you’ve ever made orange juice from concentrate, you probably have a gut feel for how equity dilution works. When you put the concentrate in a pitcher, you have a small amount of really strong juice.
When you add water, the original concentrate represents only a small portion of the remaining solution. The same holds true for cap tables.
Let’s say a company’s initial cap table looks like this:
The founders each own approximately 50% of the company. As a group, they own 100%.
Industry participants often refer to a shareholder’s ownership level as his or her ownership stake.
If the company raises some new capital, the shareholder ownership percentage gets diluted. The amount the company raises and the per-share price will dictate the amount of the dilution.
As you can see, the founders now collectively own only about 64% of the company.
So, the founders’ ownership stake decreased to 36% but they also now have $1M to grow the business.
There are two senses of dilution. In its narrowest definition, dilution is just ownership decreases due to new equity issuances.
In a more general way, dilution is the loss of value of existing shares due new equity terms.
Imagine two term sheets a company is considering–Term Sheet A and Term Sheet B. Both A and B offer the company $1,000,000 at $10 / share. But B has an additional provision where the preferred have a 2x liquidation preference.
In the narrow sense, the dilution will be identical for both term sheets. As we showed above, the new investors will own ~36% of the company and the founders will be diluted down to ~64% as a group.
However, the value of the founders’ shares will be significantly lower with Term Sheet B. This is because the Term Sheet B investors get 2x their money back before the founders get anything. You can learn more about this by reading our article on waterfall analysis.
Equity dilution is the decrease in existing shareholders’ ownership of a company as a result of the company issuing new equity. We call this “narrow” dilution. It can also refer more broadly to the result of any action that decreases the economic value of existing shareholders’ ownership. We call this “broad” dilution.
The Equity Equation: Why Dilute?
So how should a founder think about equity dilution? Paul Graham said it best in his Equity Equation article. You should think about dilution in terms of this simple equation:
Value of Ownership after Dilution > 1 / (1 – N)
Where N = the amount of ownership you are giving up as a percentage.
The basic idea of the equity equation is that you want to maximize the value of your ownership stake.
If you dilute your ownership stake by N, then your company’s value would have to increase by 1/ (1-N) to make your equity worth the same as it was before you diluted your stake.
It’s pretty simple math.
If you owned 50% of a company valued at $1M, your stake would be worth $500K. If you get diluted by 20% by issuing new shares and the value of the company stayed the same, your stake would be worth $400K. So your stake is worth $100K (20%) less than it was.
To keep your value the same, you need your new ownership–40%–times the company’s value (let’s call it V) to equal $500K. Simple algebra solves V at $1.25M.
$1.25M is 1.25x the original value of the company–$1M. So, if our math is right 1 / (1-N) should be 1.25.
1 / (1-20%) does indeed equal 1.25.
A common source of confusion in this math is the difference between percent decrease and decrease in percentage points. In the example above, we modeled a 20% decrease from a 50% ownership stake. 50% * (1-20%) = 40%.
It’s easy to think if you own 50% and have 20% dilution, you would be left with 30%. It’s fine to think about it that way but you just need to be clear that you are measuring dilution in percentage points not percent decrease.
Industry participants use both approaches. Just be careful to be clear about which you are using.
In our example, as long you feel like your company will be worth more than 1.25x by issuing new shares, then you should do it. If you feel like it will be worth less than 1.25x, you shouldn’t.
Determining what will make a company worth 1.25x more goes beyond the scope of this article. But check out some of our other articles on the topic.
Sources of Dilution
Most startup executives think dilution only comes from issuing new equity to investors. This is what we have called “narrow” dilution.
But as Dries Buytaert points out in a great post, dilution can come from several different sources. This is what we would call broad dilution.
There are quite a few sources of narrow dilution to be aware of:
- Issuances of new preferred stock–typically to raise money
- Issuances of new common stock–typically to co-founders, etc.
- Issuances of new stock options–typically to new hires
- Issuances of warrants–typically to lenders
- Increases in the conversion rate of preferred to common shares–this typically happens in recapitalization situations
- Issuance of convertible debt–it isn’t dilutive now but it will be at some point
There are also quite a few sources of broad dilution:
- Liquidation preferences
- Participation rights
- Cumulative dividends
- Many other terms–see our term sheet guide for more information.
Free Equity Dilution Calculator
In theory, it is really easy to illustrate dilution from a new equity raise. In real life, a CFO at a startup has to do a lot of math. This is even more true if you want to understand narrow and broad dilution from a new round.
The CFO often needs to take into account:
- New shares from equity investment
- Conversion of convertible notes with warrants, valuation caps, and / or discounts
- Issuance of new options before and/or after the round
- Repurchase of stock as part of the new round
- The waterfall impacts of new round
There are a lot of useful simple equity dilution calculators on the web. Our favorite is here.
But if you need to model a real-life fund raise, we recommend creating a free acount on Shareworks Startup Edition. Using the software, you can use the financing round tool to easily model the effects of dilution for your own cap table.
Here is what you need to do:
- Go to our website and click the “Get Started” button
- Upload your existing cap table, or click on the “View a Demo Cap Table” option
- Click on the menu icon (), then click on the “Financing Rounds” link
- Click on the “New Financing Round” button
At this point, you will see something like this:
This a real-world dilution calculator that will handle all of the issues we mentioned above.
Waterfall Analysis and Equity Dilution
Modeling broad equity dilution requires understanding waterfall analysis.
Waterfall analysis is an understanding of payouts to shareholders at any company valuation and how these payouts change based on different equity terms.
Waterfall analysis is a whole topic by itself. But if you use our solution's free equity dilution calculator, it will perform a waterfall analysis for you automatically.
This will allow you to plug in any company value and see what the returns to every shareholder would be.
To get to the waterfall analysis, go to the menu again and click on Scenarios > Waterfall analysis. From here, you will see a screen like this.
From here, you can analyze the returns to any shareholder at any equity value for your company.
Real World Dilution Statistics: Equity Dilution Norms and Benchmarks
We recently published an equity report that includes big data analysis on hundreds of equity situations from our experience of working with 5,000+ companies.
Here is some of the data about dilution rates:
Employees typically retain a majority stake in startups until somewhere around the Series B stage.
Be careful though because the employee stake includes options and other derivatives. Sometimes options aren’t counted as “real” stock for corporate votes.
Also, sometimes a company’s board controls the company more than the shareholders. So employees might own more than half of the fully diluted shares but not have control.
Our research also shows it’s not uncommon for founders as a group to own less than 35% of their company at exit.
Based on our research, executives should plan on giving up meaningful but decreasing amounts of equity at each new fundraising stage.
If you enjoy math, it’s cool to see that you can predict founder’s ownership in a company almost perfectly by stage.
In conclusion, equity dilution is one of the most important concepts for startup executives.
Knowing how to model and manage are key skills for any private company CFO.
Finally, real-world benchmark data can help you make sure you are on the right track. Download the full report below for more information.
If you would like a personal demonstration of how Shareworks Startup Edition can help you calculate dilution and run powerful scenarios, just click here to request a demo.