Equity Dilution: How It Works In Startups

If you have been in the startup world for a while, you may have heard about dilution and have a vague idea that it is a bad thing. This article aims to help founders and employees understand the concept and how it affects them.

Dilution refers to the reduction of the percentage ownership of the company held by its shareholders—founders, employees and investors—when additional shares are issued. As the total number of shares is increased, the shareholder’s number of shares remains fixed, resulting in a smaller percentage stake in the company.

Founders and employees should understand that dilution is an inevitable part of the startup journey. Startups need to raise capital to grow, and everyone is diluted along the way. However, this is not necessarily a bad thing.

What Causes Dilution

The most common events that cause dilution in a startup are:

• New Round of Funding. One common cause of dilution is a new round of funding. Startups require capital to grow and expand their operations. They typically raise funds by issuing new shares to investors, such as venture capitalists or angel investors. When new shares are issued, the total number of outstanding shares increases. This reduces the percentage ownership of the founders or early shareholders in the company.
• Exercising Options. Another cause of dilution is the exercising of options. Options are contracts that give the holder the right to purchase stock at a specified price within a specific period. Startups often use stock options as a form of compensation for employees, advisors and consultants. When these options are exercised, new shares are issued and the total number of outstanding shares in the company increases, which reduces the percentage ownership of the founders or early shareholders.
• Conversion of SAFEs. Simple Agreement for Future Equity (SAFEs) are a popular form of financing for startups. SAFEs are a promise of future equity in a startup and are typically used by Pre-seed investors. When a SAFE converts to equity, new shares are issued and the total number of outstanding shares increases, which reduces the percentage ownership of the founders or early shareholders.

Example of Dilution

Let’s say our startup Gregarious Games, Inc. has 10 million shares outstanding. The founder James has 2 million shares, which represents a 20% ownership stake (2,000,000 / 10,000,000 = 0.20).

During their Series A, they issued another 1 million shares. At this point, the company has 11 million shares outstanding. James still owns 2 million. His ownership percentage has now shrunk to 18% (2,000,000 / 11,000,000 = 0.1818).

Dilution Is Inevitable, But Not Necessarily Bad

Does this mean that the dollar value of James’ stake in the company has decreased? Not necessarily. Ideally, at each round of funding, the startup’s valuation has increased. If the overall value of the company has increased, James’ stake may be worth more even though the percentage ownership is lower.

For example, let’s say James’ shares were worth $1 prior to the round of funding, and the shares are worth $1.50 after the funding. Then, the value of his shares increased from $2 million to $3 million even though his percentage ownership decreased from 20% to 18%. If the overall size of the pie increases, and you have a slightly skinnier slice, then you may still end up with more pie.

The Impact of Equity Dilution on Existing Shareholders

As new shares are issued during funding rounds, the percentage ownership of existing shareholders decreases. This can affect their voting rights and potential returns on investment, as well as decrease motivation among existing employees who may feel that the value of their equity compensation is decreasing with each funding round. This could potentially result in higher employee turnover rates and increased costs associated with hiring and training new team members.

Startups should communicate openly with existing shareholders about the impact of equity dilution and provide them with regular updates on the company’s progress and future plans. By doing so, startups can foster a sense of transparency and trust among shareholders while mitigating potential negative consequences associated with equity dilution.

While equity dilution is often necessary for startups seeking growth and expansion, it’s crucial for founders to consider its impact on existing shareholders carefully. By taking steps to mitigate these effects and communicating openly with stakeholders, startups can maintain positive relationships with investors and employees while achieving long-term success.

Communicating Effectively with Shareholders About Equity Dilution

When it comes to equity dilution, communication is key. Founders must be transparent with their shareholders—employees and early investors—about the impact of funding rounds on existing shareholders’ ownership percentage and potential returns on investment.

To communicate effectively with employees about equity dilution, founders should:

• Be Upfront and Honest. Provide shareholders with clear and concise information about the impact of funding rounds on existing shareholders’ ownership percentage. Explain how this will affect potential returns on investment and any anti-dilution protections in place.
• Provide Regular Updates. Keep shareholders informed about the company’s progress and future plans by providing regular updates on revenue growth, customer acquisition and any upcoming funding rounds that may impact equity dilution.
• Listen to Feedback. Be open to listening to feedback from shareholders and addressing any concerns they may have in a timely manner.

By following these principles, founders can communicate effectively with their shareholders about equity dilution while maintaining positive relationships built on transparency and trust.

Best Practices for Managing Equity Dilution Over Time

To manage equity dilution over time, founders can follow these best practices:

1. Create a Plan. Startups should create an equity management plan that considers potential future funding rounds, employee equity compensation, and potential exits or initial public offerings (IPOs). The plan should include clear guidelines on how equity will be distributed among stakeholders and how dilution will be managed over time.
2. Use Equity Sparingly. While equity can be a valuable tool for attracting top talent and raising capital, it should be used sparingly to avoid excessive dilution of existing shareholders’ ownership percentage. Startups should consider alternative funding sources such as debt financing or revenue-based financing before turning to equity financing.
3. Implement Vesting Schedules. Vesting schedules can help mitigate the risk of early departures from the company. By implementing vesting schedules, startups can protect existing shareholders’ ownership stake while aligning equity compensation with an employee’s contribution to the company.
4. Review Cap Table. Cap tables provide a snapshot of current ownership percentages in a company and are vital for managing equity dilution over time. Startups should regularly review their cap tables to ensure that they accurately reflect the current distribution of ownership among stakeholders and adjust their equity management plan accordingly.
5. Communicate. Startups should communicate transparently with all stakeholders about the impact of funding rounds on existing shareholders’ ownership percentage and potential returns on investment. By fostering a culture of transparency and trust, startups can maintain positive relationships with investors and employees while achieving long-term success.

By following these best practices for managing equity dilution over time, startups can ensure a fair distribution of equity among all stakeholders while achieving their long-term business goals.