What is Equity Dilution?
Equity dilution in startups is defined as the decrease in equity ownership for existing shareholders that occurs when a company issues new shares. In other words, dilution decreases a shareholder’s ownership stake in a startup. However, there are additional factors outside of issuing new stock that can also decrease a shareholder’s equity.
A subject near and dear to entrepreneurs, equity dilution is an important topic to understand for both leaders at private companies and particularly, startups. Typically, a founder starts out owning 100% of the company and, every time capital is raised, or shares are issues, the overall proportion of equity owned by the founder is reduced. Below, we go over the definition of stock dilution and provide you with a hypothetical dilution of shares example and what it can look like in action.
The Meaning of Diluted Shares
Equity Dilution takes place when a company issues new stock. Most often, this results in decrease in the ownership percentage of a shareholder. A phenomenon that goes by many names, equity dilution is also known as “founder dilution,” “stock dilution,” “private company dilution,” and “startup dilution.”
If you’ve ever made orange juice from concentrate, you can already picture how equity dilution works. When you put the concentrate in a pitcher and add water to it, the original concentrate represents only a small portion of the remaining combination. The same is true for cap tables.
Stock dilution, also known as share 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.
Equity Dilution Example
Let’s consider a hypothetical example: If two founders own 50% of a company, as a group they own 100%. If the company raises new capital, the founders’ ownership stake and earnings per share get diluted. Furthermore, the amount of capital the company raises, combined with the per-share price will determine the degree of equity dilution.
Let’s say that Company A raises $1 million at $10 per share from a venture capital firm.
The founders now collectively own only about 64% of the company and each has an ownership stake that has been decreased to 36%. However, they now have $1M to grow the business.
There are two sides of equity dilution. In its narrowest definition, dilution is simply ownership decreases due to new equity issuances. In a more general sense, dilution refers to the loss of value of existing shares due new equity terms. Imagine two term sheets being considered by a company–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.
The Bottom Line
For founders and investors, equity dilution can have a dramatic impact on ownership stake. Whether you already have a company equity plan in place, or you plan on establishing one, equity dilution may be one of the topics that are top of mind for you. Leveraging the concepts outlined in this blog, you should now be able to more clearly understand what equity dilution is and how stock option dilution works at a basic level. In the next section of our equity dilution guide, we dive into how equity gets diluted and what the dilution process looks like.
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