Understanding Equity Dilution

Mar 30, 2023

For private companies, fundraising decisions are critical to facilitating growth. To make an informed decision, however, it’s important to understand the long-term implications of equity dilution.

Q
What is Equity Dilution?
A

Equity dilution is defined as the decrease in equity ownership for existing shareholders that occurs when a company issues new shares. Typically, a founder starts out owning 100% of a company and, every time capital is raised or shares are issued, that ownership stake is reduced. This is why equity dilution is sometimes called founder dilution. It is also known as stock dilution, share dilution, private company dilution and startup dilution.

Q
How Does Equity Get Diluted?
A

To understand how dilution works in practice, consider this example. Let’s say the founder of a company valued at $2 million owns 100 shares, representing a 100% ownership stake. To finance growth, the company raises an additional $500,000 and issues 25 new shares to its new investor, increasing the total pool of shares to 125. Despite still owning 100 shares, the founder’s ownership stake drops to 80% (100 out of 125), while the new investor now owns 20% of the company (25 out of 125). After enough equity dilution takes place, the founder’s stake may be reduced to less than 50%, risking the loss of majority voting power.

However, while the founder’s ownership stake has declined, the total post-money valuation of the company is now $2.5 million—meaning the founder’s 80% stake is still worth $2 million. That’s why founders and early investors may be willing to accept some measure of equity dilution as long as the valuation of the company rises.

A challenge arises if, due to market conditions or underperformance, the valuation of the company declines. In this case—or if a founder is at risk of losing ownership control—some founders and early investors may seek protection through anti-dilution measures.

Median Employee Dilution by Stage in Percentage Points

Q
What Are Anti-Dilution Measures?
A

Anti-dilution protection can help protect from dilution when shares are sold at a price per share that is less than the price paid by earlier investors. Also known as subscription privileges, subscription rights and pre-emptive rights, there are two common types of anti-dilution provisions:

  • Full rachet anti-dilution measures allow investors to maintain nearly the same ownership stake as before the company’s valuation declined, compensating for any dilution caused by future fundraising rounds.
  • Weighted average anti-dilution measures determine the rate of dilution based on the amount of money and price per share previously raised compared to the amount of money and price per share raised during future financing rounds. While they do not eliminate dilution, they reduce the rate of dilution that would otherwise occur.

 

Q
What are Some Common Sources of Equity Dilution?
A

While the most common source of equity dilution is fundraising, there are several other scenarios where equity may get diluted. For instance, if employees are awarded restricted stock units (RSUs) as part of their equity compensation, existing shareholders will see their equity diluted when those RSUs vest. Similarly, if a company issues convertible debt, current shareholders will be diluted if those notes are converted into new shares. The same is true if stock option holders exercise their options and become shareholders. 

Q
How is Equity Dilution Calculated?
A

A basic formula for calculating equity dilution is to divide a current shareholder’s total number of existing shares by the sum of the total number of outstanding shares + the total number of new shares, as shown in the example above.

 

In practice, however, multiple factors go into the calculation of equity dilution, such as:

  • New shares from equity investment
  • Shifts in company valuation
  • Conversions of convertible notes with warrants, valuation caps, and/or discounts
  • Issuance of new options before and/or after the fundraising round
  • Repurchase of stock as part of the new round

Given these complexities, some companies may rely on equity administration software to help model various fundraising scenarios and calculate dilution. Find out how Morgan Stanley at Work can help you calculate share dilution so that you can maintain an accurate cap table.