Share dilution

Share dilution is the reduction in an existing shareholder’s ownership percentage after a fundraising round. Learn how to prepare your startup for dilution.

What is share dilution?

Share dilution occurs when a company issues new shares of stock, which reduces the ownership percentage for existing shareholders. Also known as stock dilution or equity dilution, share dilution can happen due to raising capital during a new fundraising round, changes to an employee stock option pool, conversion of convertible securities, a merger or acquisition, an initial public offering (IPO), and other material events.

Essentially, when a private company increases the number of outstanding shares, its founders, employees, and investors are generally all subject to share dilution.

Causes of share dilution

When a startup is founded, new shares are issued to the founders and early investors. But as the company grows, it may need to issue additional shares to raise capital, acquire target companies, or attract top talent. Common causes of share dilution include:

• Fundraising rounds: When private companies need more money, they typically issue new shares to investors in a funding round, which reduces the overall percentage of ownership for current shareholders. The larger the investment round, the greater the potential for share dilution. However, additional capital may also increase the company’s valuation, thereby offsetting any potentially negative effects of dilution on founders, investors, and employees.

• Employee option pools: Incoming investors usually require companies to create a stock option pool. The timing of when the stock option pool gets created determines which shares are diluted. For example, if the option pool is expanded before a fundraising round, only previous option holders face dilution. If the pool is expanded after a fundraising round, then all shareholders—including new investors—will feel the effects of dilution.

• Convertible securities: Convertible instruments such as SAFEs (Simple Agreement for Future Equity) and convertible notes allow investors to provide funding for the right to convert their investment into shares at a future date, typically at a discount or pre-set valuation, which can lead to dilution.

• Going public: An IPO is when a private company lists its shares on a public stock exchange for the first time, allowing those shares to be bought and sold on the open market. Every IPO involves the listing of a company’s existing shares. In some cases, public companies also issue new shares (known as a secondary stock offering) after the IPO. Secondary offerings lead to dilution for existing shareholders.

Effects of share dilution

When a company initially issues stock, each share represents a fixed percentage of ownership. However, with issuance of additional shares, each existing share represents a smaller fraction of the company’s total equity. This can lead to changes in:

• Ownership percentage: Each existing shareholder owns a smaller proportion of the company.

• Earnings per share (EPS): With more shares outstanding, each shareholder receives a smaller share of earnings and a lower payout percentage in an exit event.

• Voting power: If the newly issued shares come with voting rights, existing shareholders may lose influence over business decisions.

• Share price: If share dilution does not come with an increase in the value of the company, the price per share may decline, and investors may see their investment devalued.

Share dilution example

Single founder: Let’s say you’re the sole owner of your company and you own 10,000 shares or 100% of the company. Business is going well, so you decide to create an employee option pool of 1,000 shares for future employees. You also are in need of more capital, so you give an investor 2,000 shares in return for their investment. In total, there are now 13,000 shares of company stock outstanding (on a fully diluted basis)—and just like that, you now own only 77% of your company (10,000/13,000) instead of 100%.

Multiple founders: Let’s say you’re one of two co-founders of a startup, in which each co-founder owns 50% of the company (5,000 shares issued to each of you). Your company needs additional capital to expand, so a VC firm invests and you issue 2,000 shares in return. After those new shares are issued, the total number of shares in the company is now 12,000. Each co-founder still owns 5,000 shares, but now their ownership stake is 42% (5,000/12,000) instead of 50%.

SAFEs and share dilution

A SAFE (Simple Agreement for Future Equity) allows you to raise money from investors in exchange for future shares of stock in your company. SAFEs can be a convenient way to raise money when your company is young, however they can also be dilutive.

How does equity dilution work when raising a SAFE?

SAFEs postpone equity dilution until your next qualified financing (usually your seed round or Series A). SAFE holders get shares in the future, typically at a discount in exchange for investing in your company at an early stage. This means that ownership percentages won’t be calculated until a new company valuation is determined.

What type of SAFE are you issuing?

The type of SAFE you raise ( pre-money vs. post-money SAFEs) can impact your eventual equity dilution.

With pre-money SAFEs, each investor’s ownership percentage is undetermined until you raise your next round. This type of SAFE may be less dilutive for you, the founder, since everyone’s ownership gets diluted at the same time.

With post-money SAFEs, investors lock in the percentage of the company they’ll own before additional investors get mixed in during a priced financing round. Many investors and founders prefer this because it gives everyone a better prediction of their ownership, making it easier to plan for the future. However, post-money SAFEs are generally less founder-friendly because they only dilute the founders’ ownership percentage.

What is your valuation cap?

Many SAFEs have a valuation cap to protect the investor. A valuation cap is the maximum company valuation at which an investor’s money will convert into shares.

Is there a conversion discount?

A conversion discount gives your investor a discount on the price per share when their SAFE turns into equity. For example, if your Series A investors are paying $1 per share, your SAFE holder may only have to pay 80 cents per share.

Priced rounds and share dilution

The process of raising a priced round is usually longer and more complicated than raising a SAFE, but equity dilution is easier to calculate. In a priced round, investors give you a certain amount of money for a set number of shares based on the company valuation you agree upon.

Pre-money vs. post-money valuation

Whether you’ve raised money in a priced round based on your pre-money or post-money valuation can impact how much the new investment dilutes your ownership.

Dilution vs. capital needs

Founders have to strike a balance between the amount they aim to raise now versus future rounds, taking into account future dilution.
Here are general benchmarks for founder dilution:

*Generally if company is established and has a high valuation, the equity given up tends to be a smaller percentage.

How to minimize share dilution

While many of the things we talked about above are unavoidable, there are some strategies to minimize dilution:

Don’t raise more than you truly need to get to the next stage of your business

Don’t create a bigger option pool than you need

Don’t rush

Model your future equity dilution

Whenever you’re thinking of fundraising, no matter the method, model the impact of dilution first.