Equity dilution (commonly referred to as stock dilution) takes place when a company issues new stock which can result in a decrease of an existing stockholder’s ownership percentage of said company. When the number of shares outstanding increases, each existing stockholder owns a smaller (or diluted) percentage of the company.
This does not mean, however, that the shares are worth a lesser amount, especially if the dilution takes place when the company is expanding and the valuation has increased.
In general shares are only worth less in value if a company’s valuation has decreased, which is commonly known as a ‘down round’. Most startups are expanding and the valuation of a business is growing all the time, which usually means that your share price has gone up and you now have a small piece of a much larger pie.
How does dilution work?
Dilution is often seen in a negative light, with some investors arguing it decreases the value of their shares. However, as an investor you should only be concerned about dilution if there is a down round, or if you are a significant controller in the business, and if upon dilution, you lose control.
There are several situations in which equity dilution can take place. These include:
- The need for new capital: When private companies require more capital, they typically issue new shares to investors in a funding round, which reduces the overall percentage of ownership for existing shareholders.
- Offering new shares in exchange for acquisitions: A company may offer new shares to the shareholders of a firm that it is purchasing
Taking the above into account, try to imagine that there are two co-founders of a startup and 1,000 shares are issued between both. This means each founder owns 500 shares, or 50%.
However, they need to raise more capital in order to expand their business. A VC firm invests in the company and receives 200 shares in return. As a result of those new shares being issued there are now 1,200 shares in the company. Each founder still owns 500 shares, but their ownership stake is 42% (500/1200) instead of 50%.
“Of course, the downside to this is that you have much more responsibility and if you are looking for an easy lifestyle business, then utilising private investor’s capital is not for you. Investors will require you to hit certain targets and you have a responsibility to report to them on a monthly basis.”