How Does Equity Get Diluted?
In this section of the Equity Dilution Guide, we’ll focus on both how equity gets diluted and how it affects shareholders. To recap “What is Equity Dilution?,” part one of our Equity Dilution Guide, equity dilution essentially refers to a decrease in the percentage of share ownership by investors. Keep in mind that equity dilution goes by many names, including stock dilution, founder dilution, and startup dilution.
Below, you’ll have the chance to learn how some founders think about dilution, how equity dilution works, and how it takes place over time.
Equity Dilution Example: How Ownership Stake Gets Diluted
While many founders know how equity dilution works at a basic level, understanding the most likely ways that dilution takes place over time is more complex. You may be interested in determining how much your equity will be worth over a three-year period or a 10-year period, but how do you go about this?
At the core, company ownership is broken down by shares. And when a new startup is formed, founders typically own 100% of their startup’s shares:
When new funds are raised, equity is given to investors. While the founders still own the same number of shares (100), their ownership stake is ultimately decreased by the introduction of new shares. In this example, we add 50 shares to the overall pool:
In this example, the founders’ ownership stake was decreased from 100% to 66%, and as new investors are introduced, their ownership stake will be reduced further. After enough equity dilution takes place, their stake may be reduced to less than 50%. At that point, the founders risk losing control of the company’s direction and voting power in many cases. Because of this, some founders resort to protecting themselves against dilution using anti-dilution practices.
Why a Founder May Take Anti-Dilution Measures
An anti-dilution protection refers to the practice of mitigating the dilutive effect of issuing new stock for specific shareholders. When it comes to venture financing, anti-dilution provisions protect from dilution when shares are sold at a price per share that is less than the price paid by earlier investors. As with equity dilution, anti-dilution provisions also go by many different names, including “subscription privileges,” “subscription rights,” and “preemptive rights.” It should be noted that, as long as the value of the of the stock held by investors continuous to rise, they may not be particularly concerned about equity dilution. However, in the event that the value of the company decreases, investors are more likely to want anti-dilution protection.
Commonly, decision making power and control over the company’s direction are directly tied to ownership stake percentage and the type of shares held by investors. As mentioned earlier, in some cases, investors can become outnumbered if their ownership stake is diluted enough. When that is a risk, anti-dilution measures come into play. Below are the two most common types of anti-dilution provisions:
Full Rachet: In full ratchet anti-dilution, investors have the ability to maintain nearly the same ownership stake as before the company’s value was decreased. Full ratchet is an anti-dilution provision that, in a nutshell, requires that early investors are compensated for any dilution caused by future fundraising rounds.
Weighted Average: More common than full ratchet anti-dilution protection, weighted average anti-dilution adjusts the rate at which preferred stock converts into common stock based on two factors:
- The amount of money previously raised by a company and the price per share at which it was raised.
- The amount of money raised by the company in future financing rounds and the price per share during that process.
Continue Learning About Equity Dilution
Dilution of shares is a common scenario at any startup, but not everyone understand why it occurs or how it comes to pass. In this post we explored a simplified example of how equity gets diluted and how it can affect the ownership stake of investors. In some cases, a founder’s ownership stake can be diluted to the point where he or she actually voting power or control when it comes to the company’s direction. In these cases, anti-dilution clauses are usually incorporated to protect the ownership stakes of certain investors.
In part three of the Equity Dilution Guide, we explore step-by-step how to calculate equity dilution using the equity dilution formula.