How Does Startup Equity Dilution Work?

Starting a company is exciting. The development and growth of your business will eventually require outside funding to implement expansion plans and attract new talent for market growth. When accepting outside investment, your company must provide investors with an ownership percentage of its equity capital. Generally, startups use equity dilution as their solution.

Anyone involved in startups must have the answer to these questions—how does startup equity dilution work, how to calculate equity dilution​, or how to calculate my dilution on an offering. As new investors invest in your company, you may lose ownership because of dilution. When startup founders and early investors plan without caution, their ownership shares tend to reduce substantially. In this blog, we are going to explain this concept in a simple language. 

What Is Equity Dilution?

When a company distributes new shares through the market it causes equity dilution which decreases present shareholders' ownership stake. Multiple funding rounds within startups often cause this situation to occur.

Let’s understand it with an example. Imagine a startup that belongs equally to two founders who split ownership 50-50. When they undertake share sales for investor funding, their ownership stake in the company gets reduced. The company ownership remains theirs, but the percentage reduces compared to the initial value.

Dilution allows shareholders to invest in a reduced portion of the company, and it does not necessarily bring negative consequences. In fact, you might be getting more money for your stake in the company post equity dilution. This happens because the valuation increase gives your smaller share stake a greater value than your bigger stake had it in the initial valuation period.

How Does Startup Equity Dilution Work?

Startups distribute new shares to their investors whenever they seek funding. When a startup issues new shares it increases the total share number resulting in lower ownership percentages for existing shareholders.

The following example explains the concept of equity dilution in more detail.

During its first round of funding, the startup founders and initial investors hold 1 million shares. When the company distributes 200,000 new shares to investors in the next round of funding, the overall share issue reaches 1,200,000. Following the issue of new shares, the existing shareholders experience reduced ownership as their expanded shares form a smaller fraction within the total shares.

The degree of dilution depends on the quantity of new capital a company secures alongside the number of issued shares. Company founders need to assess the financial gain of raising capital along with ensuring they do not diminish their operational authority.

How to Calculate Equity Dilution

Founders and investors need to measure exactly how much ownership share they will get after funding rounds. Here’s the formula for how to calculate equity dilution: 

1. All pre-investment shares that existed before the new financing events should be identified.
2. Total shares will result from adding new issued shares to the current existing shares.
3. Your ownership reaches the ratio between your initial shares and the updated total shares.

Formula:

Ownership after equity dilution is calculated by dividing the number of original shares by the total number of shares outstanding after the new shares are issued.

Let’s understand it with an example. You have 200,000 shares from a startup launch with 1,000,000 total shares. The funding round leads the company to create 250,000 new shares for distribution.

The total number of shares after this funding round: 1,000,000 + 250,000 = 1,250,000.

Your new ownership percentage = 200,000 / 1,250,000 = 16%

Prior to the round, you possessed 20% stake (200,000 shares from 1,000,000 total shares). After dilution, you own 16%. Your ownership percentage declined yet the company's growing value may result in increased absolute value of your share worth.

How to Calculate My Dilution on an Offering

Being an investor or a startup founder, one must determine the anticipated equity dilution rate from each funding offer. The following method shows you how to perform dilution calculations:

1. Determine your current number of shares before starting the new investment.
2. Figure out the quantity of new shares which will emerge in this offering.
3. You should use the previously demonstrated formula to determine your altered ownership stake.

Let’s assume that you currently hold 5% of startup ownership while the company plans to expand its share class by issuing 20% more shares. As a result, your ownership stake will get diluted. Your shares after the issuance will reduce slightly from 5%, because the total new share count rises.

Startups should organize their capital investment phases to obtain the required funding without creating unnecessary shareholder dilution. Long-term investors need to gauge dilution's effects on their returns while also seeking safeguarding provisions with the investment terms.

Ways to Manage Equity Dilution

Equity dilution emerges naturally from fundraising yet organizations can implement certain strategies for its control:

• Negotiate investment terms: Early investors could negotiate with the company to include anti-dilution clauses that protect their equity ownership throughout subsequent funding stages.
• Use stock options wisely: Employ the stock options with consideration about their effects on dilution for your workforce. Strategic planning should guide the establishment of an Employee Stock Option Pool (ESOP).
• Plan funding rounds carefully: The timing of funding rounds needs careful planning. Obtaining excessive capital at the beginning often results in an unnecessary founder equity dilution. So, startups should manage their growth needs against maintaining ownership control.
• Consider alternative funding sources: Use convertible notes together with revenue-based financing as alternative approaches to postpone dilution until the startup reaches higher valuations

The Impact of Equity Dilution on Founders

The ownership percentage that founders relinquish through equity dilution leads them to lose company control. New investors, who join the company, often wish to have input on corporate decisions. Excessive dilution depletes founder ownership beyond a majority position, making it challenging to guide the business their preferred way.

Founders can prevent dilution by designing their fundraising steps according to a strategy. That’s why, founders often prefer to sustain their business through their own resources until they need outside funding. Some founders preserve control by implementing staggered fundraising methods as well as special voting rights.

Investor Protections Against Equity Dilution

Investors must take steps to shield themselves against major reductions in their share ownership when equity dilution happens. Many early investors incorporate protective provisions to maintain their shareholdings during subsequent financing events in their startups. Anti-dilution provisions modify shareholder percentage based on when the company performs a down round funding at a reduced valuation.

When companies issue new stock, investors get extra shares to maintain their existing stake through pro-rata rights in follow-on investments. Learning about these investment protections allows investors to improve their negotiation approaches and define the final terms for investment. 

When Does Equity Dilution Become a Problem?

The consequences of excessive equity dilution are:

• Loss of control for founders: Founders may lose executive power because their ownership decreases to levels that they find unacceptable.
• Reduced investor returns: Business returns to investors turn unprofitable following a failed dilution management strategy, because of diminished ownership value.
• Demotivation of key stakeholders: Significant stake reductions by investors will reduce motivation levels among all key stakeholders. This situation leads to decreased employee commitment at the workplace.

Proper funding strategy management benefits all parties in a company, including investors and founders along with workers, during periods of business growth.

Understanding Cap Tables and Dilution Modeling

A capitalization table, commonly referred to as a cap table, serves as an essential document for recording ownership details along with equity shares among shareholders. All shareholders participate in this document that displays their ownership percentage to show how equity distribution changes throughout time.

The dilution modeling technique allows startup companies to predict how much equity dilution will happen when they secure funding from various sources. Founders, together with investors, benefit from financial modeling systems to forecast dilution results when deciding about fundraising.

The existence of an accurate cap table prevents unexpected results and provides absolute transparency about stake equities for both company founders and investors during business expansion.

The Big Picture

Equity dilution isn’t necessarily bad. Startups that experience growth will make even minimal share ownership more valuable with time. While equity dilution, the knowledge of ownership alterations enables founders and investors to make better decisions.

The comprehension of startup equity dilution principles enables founders to create effective financing strategies, strike better deals, and maintain their initiative ownership. Start-up founders and venture investors, who want to make strategic decisions, can achieve advantages by mastering equity dilution calculation. We hope you must have got the answer to all the questions related to equity dilution, like how does startup equity dilution work, how to calculate equity dilution​, or how to calculate my dilution on an offering. 

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