Imagine a startup with 100 outstanding shares. You own ten shares, giving you a 10% ownership stake. The startup raises funds by issuing 50 additional shares, increasing the total to 150. While your ownership remains ten shares, your stake has reduced to 6.67% since the total number of shares has increased.
What happens above is share dilution.
Share dilution refers to reducing a shareholder's ownership percentage in a company by issuing additional shares. This process reduces the equity stake of existing shareholders, allowing the newly issued shares to be used to raise capital.
Share dilution can affect your financial stake in a company and your control over its operations.
Dilution is important for a startup's growth because issuing new shares helps attract funding. It balances short-term ownership sacrifices with the potential for significant long-term gains as the company expands and succeeds.
Key takeaways
- Share dilution refers to reducing a shareholder's ownership percentage in a company by issuing additional shares.
- Dilution is important for a startup's growth because issuing new shares helps attract funding.
- Raising capital causes share dilution because new shares are issued in exchange for investment, reducing the ownership percentage of existing shareholders.
- To minimize dilution, founders should keep a significant share, allocate a small ESOP pool, raise capital in planned rounds, and offer equity-based incentives to early contributors.
- When selecting online tools for dilution calculation, consider factors such as cost, an easy-to-use interface, the ability to customize scenarios, accuracy, and the inclusion of advanced features like anti-dilution provisions.
Primary causes of share dilution
- Raising capital causes share dilution because new shares are issued in exchange for investment, reducing the ownership percentage of existing shareholders.
- Stock options or warrants can also dilute shares in the future because they give individuals the right to purchase more shares later, increasing the total number of shares when exercised.
- When debt holders convert their debt into shares, typically during a funding round or exit event, it causes dilution for existing shareholders by increasing the total number of shares outstanding.
Impact of dilution on founders, employees, and early investors
Founders
Dilution can reduce founders' control and financial gains since the ownership percentage decreases as more shares are issued. However, dilution is often necessary to secure growth funding, which can increase the overall value of the reduced stake.
Employees
Employee stock options or equity-based compensation may also decrease in value because of dilution. However, companies may issue additional options to maintain employee morale and retention.
Early investors
Early investors face a reduction in their ownership percentage, which can reduce their influence in the startup. They accept dilution for more funding, which can lead to higher valuations and greater returns despite smaller ownership.
Written by Omoruyi Edoigiawerie, a seasoned startup attorney with over a decade of experience. Learn more.
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How to calculate share dilution in a startup
Step-by-step process for calculating in a startup
Step 1: Identify the initial number of shares
The first step to calculating dilution in a startup is to identify the total number of shares outstanding before the new shares are issued, including all shares held by founders, employees, and investors.
Step 2: Determine the number of new shares issued
The next is to determine the number of shares to be issued in the new funding round, whether for investors or stock options.
Step 3: Calculate the total shares after issuance
This step requires you to add the number of new shares to the total number of outstanding shares using the formula below.
Total Shares After Issuance = Existing Shares + New Shares
Step 4: Calculate ownership percentage before issuance
Then, you calculate the ownership percentage before the issuance for each stakeholder using the formula below.
Ownership Percentage (Before) = Shares Held by StakeholderExisting Total Shares ×100
Step 5: Calculate ownership percentage after issuance
You will also calculate each stakeholder’s ownership percentage after issuance.
Ownership Percentage (After) = Shares Held by StakeholderTotal Shares after Issuance ×100
Step 6: Determine the impact of dilution
The last step requires you to subtract the ownership percentage after issuance from the ownership percentage before issuance to find the dilution impact for each stakeholder using the formula below:
Dilution Impact = Ownership Percentage (Before)−Ownership Percentage (After)
Factors affecting dilution calculation
- Pre-money and post-money valuation: The connection between the company's valuation before and after the funding round affects the amount of equity exchanged for the acquired capital.
- Total number of new shares: The more shares a company issues, the more significant the dilution impact on current shareholders.
- Ownership percentage: The change in ownership percentage is key to determining the level of dilution. When new shares are issued, existing shareholders' ownership percentage is reduced because the total number of shares increases, resulting in dilution.
- Startup’s valuation: A higher valuation can lead to fewer shares issued for the same amount of funding, reducing the dilution impact.
Advanced dilution scenarios
Since dilution occurs when a company issues additional shares, reducing the ownership percentage of existing shareholders, complex dilution scenarios, such as convertible notes, SAFEs, and anti-dilution provisions, can significantly affect the extent of dilution. This section will examine these scenarios, including some protective measures.
- Convertible notes: A convertible note is a short-term debt instrument that can be converted into equity. This increases the total number of shares, diluting existing shareholders. However, the dilution amount depends on the conversion terms, including the valuation cap. If the company performs well and the valuation cap is low, early investors may receive a larger equity share, leading to higher dilution for founders and other shareholders.
- SAFEs (Simple Agreement for Future Equity): SAFEs are agreements for future equity that can dilute existing ownership when converted. The amount of dilution depends on the terms of the SAFE, particularly the valuation cap and the size of the funding round. SAFEs can be less dilutive in the short term but can still cause significant dilution if the startup's valuation doesn't grow as expected.
- Anti-dilution: The anti-dilution provision protects early investors when a company issues new shares at a lower price than what those investors originally paid. This often occurs in subsequent funding rounds and, without protection, would reduce the value of their shares and dilute their ownership in the company.
While anti-dilution measures protect investors from dilution, they also increase the dilution burden on existing shareholders, particularly when new shares are issued at a lower price than in previous rounds.
Two common types of anti-dilution provisions
Full ratchet anti-dilution
A full ratchet anti-dilution provision protects investors during startup funding rounds, ensuring their ownership percentage is preserved if the company issues new shares at a lower valuation in the future.
This provision adjusts the conversion price of preferred shares to a lower valuation, issuing additional shares to early investors. This protects them from dilution and fully shields their investment.
Weighted average anti-dilution
This method recalculates an adjusted share price for earlier investors based on a blend of the old and new share prices. While it doesn't completely eliminate dilution, it helps to minimize its effects. It offers a more balanced approach to dilution.
Tools and calculators for calculating dilution
Since calculating share dilution is crucial for founders and investors, several online tools can help simplify this process. Below are a few options:
Capboard
Capboard offers tools like an equity dilution and ownership target calculator, which allow users to determine the shares required to meet ownership targets. It also features funding simulations and scenario modeling to illustrate the impact of new investments on ownership stakes.
It allows users to input various parameters, such as pre-money valuation, post-money valuation, number of shares issued, and option pool size, to calculate the impact on ownership percentages.
Key features
- Cap table management: It shares the next-generation cap table with investors and shareholders.
- Funding and exit simulations: it creates a simulation of your cap table after a funding event or any other transaction type.
- Equity plans for employees: It grants stock options and allows employees to have full visibility on a vesting schedule, cliff, good and bad leaver clauses, etc.
- Investor management: it gives existing and potential investors easy access to your equity and documents.
- Virtual data room: it offers a secure space for streamlining deal-making and sharing documents.
Neos Chronos
This tool allows users to determine a founder's equity dilution after a single fundraising round or capital increase. It provides real-time updates as users adjust input values, offering immediate insights into how changes affect ownership percentages.
Key features
- It has input fields for current shares, new shares issued, and valuation caps to simulate various funding scenarios.
- It has visual outputs, such as pie charts or tables, that show ownership percentage changes for founders, investors, and other stakeholders.
- Interactive sliders to adjust investment amounts, valuations, or share issuance and see how these changes affect dilution.
Cake Equity Calculator
This calculator shows how much an early-stage founder's equity is diluted when taking on a new capital round. Users can input various values and percentages to see real-time updates, aiding in understanding the effects of multiple funding rounds.
Key features
- Interactive input fields
- Real-time output updates
- A user-friendly interface that simplifies tasks such as updating investors, issuing share certificates, and managing ESOPs.
- Multiple funding round analysis
- Cap table management tools that reduce manual spreadsheet work and provide a centralized solution for equity-related tasks.
SeedBlink
SeedBlink offers equity calculators, including an equity dilution calculator, ownership target equity calculator, and SAFE calculator. These tools help users understand how ownership stakes may be diluted over time due to new investments and other factors.
Key features
- It has tools to simulate different funding scenarios and their impact on equity.
- Charts and graphs showing equity distribution among stakeholders.
- Provides detailed analysis of how funding rounds affect ownership percentages for founders, investors, and ESOPs.
- Like others, it shows changes in ownership as new investments or funding rounds are made.
Selecting a dilution calculator
Consider the following factors before choosing a dilution calculator:
- User-friendly interface and easy to use
- Consider the ability to customize scenarios with multiple funding rounds, different security types, and varying valuation assumptions.
- The calculator should provide accurate calculations based on proper financial principles.
- Cost is also an important factor to consider. While many calculators are free, some may charge for premium features or advanced functionality. For instance, Capboard provides advanced functionality like anti-dilution and liquidation preferences for a fee.
- To address complex scenarios, look for calculators that offer advanced features, such as anti-dilution provisions, vesting schedules, and liquidation preferences. The Capboard equity calculator is the best choice for this.
FAQs about share dilution in startups
What is the formula for startup dilution?
To calculate your equity dilution, use the formula:
Dilution % = New Shares Issued Existing Shares + New Shares Issued x 100
How does equity dilution affect my ownership?
Equity dilution affects your ownership because it reduces your ownership percentage when more shares are issued, increasing the total number of shares in circulation.
How should shares be divided in a startup to minimize dilution?
To minimize dilution, founders should keep a significant share, allocate a small ESOP pool, raise capital in planned rounds, and offer equity-based incentives to early contributors.
Can dilution be avoided entirely?
No, dilution can't be avoided entirely, particularly during funding rounds or when issuing stock options. However, you can reduce its impact through careful planning, strategic funding, and managing share distribution.
What is a dilution cap?
A dilution cap limits how much an investor's ownership can be diluted in future funding rounds, ensuring they retain a minimum ownership percentage as new shares are issued.
Conclusion
As a startup founder, early-stage employee, and investor, you need to understand the impact of share dilution on ownership stakes. Share dilution reduces shareholder's ownership percentage in a company by issuing additional shares. And it can change your financial stake in a company and how much control you have over the company’s operations.
While it affects your ownership because it reduces your ownership percentage, you can reduce its impact through careful planning, strategic funding, and managing share distribution.
Some online tools and calculators can also simplify calculating share dilution. Still, you must consider factors such as cost, an easy-to-use interface, the ability to customize scenarios, accuracy, and the inclusion of advanced features like anti-dilution provisions.
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