Start-up guide to Equity Dilution

July 22, 2020

These are difficult times for businesses to raise funds. Start-ups that survive past their bootstrapping stage will generally look to raise funds by giving out shares in their start-up in return for cash from equity investors who may consist of family, venture capitalists, private equity funds (usually in that sequence) and angel investors.

Apart from raising funds, shares may be offered to key employees as an incentive to align employee with the success of the company in return for a lower salary.

Share dilution occurs from a reduction in a shareholder’s percentage of ownership in the company, caused by an increase in the total number of shares in the company.

Is dilution in itself bad? No, not if you are increasing the value of the pie. Most shareholders should understand that dilution, on its own, is nothing to be feared, as it would be better to eventually own a tiny percentage of a highly valued start-up than a majority stake in a failing start-up.

Example

Company A starts out with 2 co-founders holding a total of 10,000 shares, where each co-founder owns 5,000 shares, or 50% of the company each. The company is valued at USD 300,000 at its bootstrapping stage (without any external investment), so each of the co-founders’ 5,000 shares are worth USD 150,000.

Suppose an angel investor offers the founders a pre-money valuation of USD 1M and agrees to invest USD 500,000. The angel investor will receive 33.33% (ie, 500k/0.5m) of the company. Company A then issues 5,000 new shares to angel investor, making the total issued share capital of 15,000 shares. As a result, each co-founder is diluted to owning 33.33% (5000/15,000 shares). However, the value of the co-founder’s remains same 5,000 shares have now increased from USD 150,000 to USD 500,000.

The effects of the dilution described above can be multi-faceted, causing:

Voting Dilution – reducing the control over the company;
Earnings Dilution – amount of profits, dividends and eventually assets available for distribution upon liquidation.

Are there ways where shareholders can dilute their ownership yet not dilute their control? Yes, but it really depends on the bargaining power, priorities and relationships of the particular situation and should be a key focus in any shareholders’ agreement.

Here are some measures that can be put in place to protect shareholders from dilution of ownership and control (from the different perspectives of founders and investors):

Pre-emption rights – At the most basic level, pre-emption rights give existing shareholders the first right of refusal in buying newly issued shares before they are offered to third parties.
Anti-dilution provisions – At the more sophisticated end of the spectrum, we have anti-dilution provisions (“full ratchet” or “weighted average”) which kick in to adjust the conversion prices of convertible preferred shares (usually held by the investors) in the event of subsequent down-round investments.
Different Share Classes / Voting Rights – As an example, a founder facing dilution of ownership by issuing new shares for an employee share option pool may consider retaining full voting control by assigning no voting rights over those shares (e.g., creating a different class of shares without voting rights).
Board Seats – In many instances, retaining control of the company by negotiating on the number of directors the founders may appoint to the Board may be more effective than focusing on the voting rights of shares.

There are quite a few sources of narrow dilution to be aware of:

Issuances of new common stock–typically to co-founders, etc.
Issuances of new preferred stock–typically to raise money
Issuances of new stock options–typically to new hires
Issuances of warrants–typically to lenders
Issuance of convertible debt–it isn’t dilutive right away but it will be at some point
Increases in the conversion rate of preferred to common shares–this typically happens in recapitalization situations

There are also quite a few sources of broad dilution:

Participation rights
Liquidation preferences
Cumulative dividends
Many other terms

Generally, share dilution can be seen as a ‘necessary evil’ for survival and growth of a company. A company that is on the right trajectory of growth will generally attract more people who are interested in owning a part of the company.

Also, while share dilution may result in a reduction in the percentage ownership of the company, it need not necessarily result in a proportionate loss of control in the company if the various anti-dilution provisions are properly negotiated or put in place.