When a founder’s ownership stake is reduced as a result of the issuance of new shares, we call this equity dilution. In the previous sections of this guide, we went over what equity dilution is, and how equity gets diluted. In this article, we provide a simple overview of a helpful formula that founders may use to estimate how much their ownership stake will be diluted as a result of new shares being issued.
Before we dive into the math, it’s worthwhile to start by considering the most commons scenarios in which a founder may be subject to equity dilution:
When new capital is raised, equity is given away as a trade-off. This is a typical case that reflects the example we went through above.
- Convertible Debt
When it comes to convertible debt, a trigger event such as an exit or fundraising round causes debt holders to be converted to shareholders. As a result, the ownership stake held by the initial shareholders is diluted.
- Stock options
Similar to fundraising, stock options do not result in the issuance of new shares immediately, instead, they simply imply that someone will be become an equity holder in the future, once the options are exercised.
How Founders May Calculate Dilution with a Stock Dilution Formula
So, how might a founder go about calculating the value of her ownership after dilution takes place? We’ll show you as hypothetical example below. According to entrepreneur and equity thought leader Paul Graham1, dilution can be thought of in terms of the following simple stock dilution formula:
Value of ownership after dilution > 1 / n-n
In this equation, N is equal to the amount of ownership that is being given up as a percentage. For many founders, the goal is to maximize the value of their ownership stake. If a founder’s ownership stake is diluted by N, then the company’s value would have to increase by 1 / 1-n to make the founders equity worth the same amount as it was before her equity was diluted.
If a founder owned 50% of a company valued at $1M, her stake would be worth $500K. If her equity was diluted by 20% from issuing new shares and the value of the company stayed the same, her stake would be worth $400K. After all of this, her stake would be worth $100K (20%) less than it was.
To keep her value the same, she would need 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 the “decrease in percentage points.” In the example above, we modeled a 20% decrease from a 50% ownership stake: 50% * (1 - 20%).
It’s common to think that if a founder owns 50% and with 20% dilution, she would be left with 30%. While this isn’t technically untrue, keep in mind that we are measuring dilution in percentage points, not percent decrease.
Using Shareworks Startup Edition as Your Equity Dilution Calculator
In theory, it seems simple to determine equity dilution from a new fundraise. However, in reality when multiple factors are present, it requires a lot of complex math. This can be even more true if you’re looking to understand narrow and broad dilution, respectively, from a new round of funding.
Often, CFOs and founders need to take into account:
- New shares from equity investment
- Conversions 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
If you want to model a real-life fund raise, and calculate dilution as part of that, we recommend creating a free Shareworks Startup Edition Account. Using Shareworks, you can leverage the financing round tool to easily model the effects of dilution from your own cap table.
Here’s how to get started
- Go to the Shareworks 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, should be able to see a clear view of equity dilution that aligns with what we’ve discussed above. If you have questions about how to calculate share dilution using Shareworks Startup Edition, feel free to reach out to our team to learn more about how to use the platform. In the next and final section of our Equity Dilution Guide, we provide an overview of the sources of equity dilution.
1Graham, Paul. The Equity Equation, www.paulgraham.com/equity.html.