Equity dilution is a decrease in the ownership percentage of a shareholder in a company, particularly in the venture capital industry. This occurs for various reasons, such as the issuance of new shares, the conversion of preferred shares into common shares, or the exercising of stock options (though technically this dilution is already accounted for in the pool of total outstanding shares, even if not exercised).
What Is Equity Dilution?
Equity dilution is a decrease in the ownership percentage of a company held by individual shareholders, resulting from the issuance of new equity. This can happen when a startup fundraises or raises capital by issuing additional shares of stock.
How Does Equity Dilution Work?
Equity dilution occurs when a company issues new shares of stock, which can decrease the ownership percentage of existing shareholders. This happens when the company raises capital through a new round of funding or grants new stock options or awards to employees or executives (note: typically the existing pool of employee stock options is already accounted for).
The percentage of ownership each shareholder has is determined by dividing the number of shares they own by the total number of outstanding shares. When new shares are issued, the total number of outstanding shares increases, which in turn decreases the percentage of ownership for existing shareholders.
Dilution also occurs through the issuance of convertible notes or shares that can be exchanged for shares of common stock or the granting of new employee stock options outside of the employee pool resulting in the issuance of new shares.
Capitalization Table and Equity Dilution
A capitalization table, or cap table, is a document that lists all of the equity holders in a company, including the number of shares they own, the share price, and their ownership stake. Cap tables are typically managed by a third party like Carta or Pulley.
How Do You Calculate Equity Dilution?
Equity dilution can be calculated using the following formula:
- Dilution = Number of Existing Shares / (Total Number of Existing Shares + Number of New Shares Added)
For example, if a company had 1 million shares outstanding before issuing an additional 500,000 shares, the dilution would be as follows: Dilution = 1,000,000 / (1,000,000 + 500,00) = 0.33
The dilution would be 33%, and the ownership percentage of each shareholder would be reduced by 33%. Dilution affects all shareholders proportionally so that all shareholders would experience the same decrease in their ownership percentage. The only exception is if the shareholder has non-dilutable shares or anti-dilution protection and exercises their right to purchase more shares to maintain their percentage of ownership.
In What Situations Does Equity Dilution Occur?
Equity dilution happens in various stages of a company’s life cycle. Here are a few examples:
- Initial Public Offering (IPO): Companies that go public often issue many new shares to raise capital, resulting in equity dilution for existing shareholders. When a company introduces a Series A round of financing, it gives new investors shares and dilutes existing shareholders’ ownership stakes.
- Companies also issue additional shares of stock through secondary offerings. This happens when the company needs to raise additional capital or when existing shareholders want to sell some holdings.
- Dilution can be the result of mergers and acquisitions. For example, if a company acquires another company and pays with shares of its stock, existing shareholders will experience dilution.
- Many companies allow team members to become stockholders as a form of compensation. Typically this comes from the existing pool of employee-designated shares, but if new shares are issued, dilution results.
- Companies can also issue convertible securities, like convertible notes or preferred stock. They can later convert these into shares of common stock, resulting in equity dilution for existing shareholders when the securities are converted.
What Is The Link Between Equity Dilution And Valuation?
There isn’t a direct link between dilution and valuation, especially when the company is private. However, investors of a public company may see dilution differently and sell their shares, driving down the price of the shares and thus the valuation (or market cap) of the company.
Is Equity Dilution A Bad Thing?
Dilution can be a necessary means of financing growth and expanding a company’s operations. The new capital raised from the issuance of additional shares can be used to invest in new products, enter new markets, or acquire other companies, which can drive the company’s growth and increase its valuation in the long run.
On the other hand, dilution can reduce the value of each share and the ownership percentage of existing shareholders, which can be a negative factor for their investment. Additionally, the issuance of new shares can reduce earnings per share (EPS) as profits are spread across a larger number of shares.
What Are Some Tips To Minimize Equity Dilution?
- Startups can reduce dilution by taking on the minimum equity financing necessary to finance their operations. They can achieve this by using alternative sources of financing, such as venture debt, or revenue-based financing.
- Convertible securities, such as convertible notes or preferred stock, can minimize dilution by allowing companies to raise capital without issuing too many new shares upfront. Convertible securities can be converted into common stock later, minimizing short-term share dilution until the company’s valuation has increased.
- Startups can also negotiate favorable terms with investors to minimize dilution. For example, they can find investors willing to invest in exchange for a smaller ownership stake or provide capital in exchange for convertible securities that they can convert into shares of common stock later.
- Startups also minimize dilution through the wise use of equity incentives, such as stock options and restricted stock units. Anti-dilution provisions on a term sheet can protect existing shareholders’ ownership stakes.
What Are The Effects Of Warrants On Equity Dilution?
Warrants can help to reduce dilution by providing an alternative source of financing for companies. Warrants are financial instruments that give the holder the right, but not the obligation, to purchase shares of a company’s stock at a pre-determined price and at a specified time in the future.
On the other hand, warrants can also increase dilution. When a holder exercises a contract, they acquire additional shares of stock, increasing the outstanding shares and diluting the ownership percentage of existing shareholders. Additionally, the exercise of warrants increases the number of shares used to calculate earnings per share (EPS), reducing the company’s EPS.
What Are Some Types Of Financing That Cause Equity Dilution?
Equity financing refers to raising funds for a business by selling ownership stakes in the company to investors. This involves stocks or shares, representing a portion of ownership in the company and giving the holder a claim on part of the company’s future profits and assets. In exchange for the capital provided by the investors, the company issues stock, and the investors become company shareholders.
Equity financing does not require the repayment of funds but provides a way for companies to raise capital without taking on debt. Check out this guide for more information on equity financing.
Convertible notes combine features of debt and equity. Early-stage startups use them to raise capital without valuing their company or issuing equity during the investment.
Convertible notes are short-term loans that the investor makes to the company. The key difference is that they include a conversion feature, which gives the investor the option to convert the loan into equity later, usually at a discount to the company’s valuation at the time of conversion.
The conversion terms, such as the valuation cap, discount rate, and conversion trigger, are negotiated between the company and the investor and included in the convertible note agreement.
Convertible notes benefit the company and the investor. For the company, they provide a way to raise capital without determining an exact valuation for the business, which is difficult for early-stage startups. They also offer the company a flexible financing source that can be converted into equity if the company’s growth and valuation exceed expectations.
For the investor, convertible notes provide a way to invest in a company with the potential for high returns while preserving the option to convert the investment into equity and participate in the company’s future success. Check out this guide for more information on convertible notes.
A Simple Agreement for Future Equity or “SAFE” minimizes the impact of equity dilution for early investors and founders.
It is an agreement between the company and the investor that gives the investor the right to receive equity in the company at a later date, typically in the event of a future equity financing round.
The key difference between a SAFE and a convertible note is that a SAFE does not have an explicit interest rate or maturity date. Instead, it gives the investor the right to receive a certain amount of equity in the company at a future valuation, as determined by a future equity financing round. This allows early investors and founders to maintain their percentage ownership in the company, even as new capital is raised and the number of outstanding shares increases.
SAFEs have become increasingly popular in recent years as a way for startups to raise capital from early-stage investors without issuing equity or setting a valuation for the company. Check out this guide for more information on SAFEs.
The Effect of Pre-Money and Post-Money Valuation on Equity Dilution
A pre-money valuation is the valuation of a company immediately before it raises new capital through an equity financing round. Post-money valuation on the other hand refers to the value of the company after it receives capital. By leveraging the pre-money valuation, the investor receives a lower equity position, and the founding team and current investors incur less dilution.
To demonstrate just how different the outcomes would be, let’s look at an example. Let’s say your company is worth $500M and you’re raising an additional $100M.
- Post-money dilution = $500M/$100M = 20%
- Pre-money dilution = $500M / ($500M + $100M) = 16.66%
Using the post-money valuation, your company is worth $500M, you receive $100M and in exchange, your investors receive 20% of your company. However, if you were raising the same $100M using the pre-money valuation, you would only have to give up 16.66%.
The 3.33% difference might not sound like a lot, but let's say your company goes public at a $1B valuation. Assuming no other investors, using the post-money valuation you’d receive $800M, using the pre-money valuation you’d receive $833.33M—a difference of nearly $35M. Check out these guides for more information on pre-money valuation and post-money valuation.