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Equity Dilution: What it is and Why it Matters for Startups
Equity dilution is a crucial concept in finance and for every startup founder to understand. It refers to the reduction in existing shareholders’ equity ownership that occurs when additional shares are issued, such as during a fundraising campaign or exercising of an option pool. This process is also known as the dilution of shares or stock dilution.
It’s important to comprehend how raising capital might affect your ownership, particularly early on, because dilution can alter both your financial share in the firm and how much influence you have. This is known as the dilution effect.
The startup ecosystem is heavily reliant on wealth creation, and stakeholders are continuously looking for varied structures to define the equity distribution of the company. Founders are often caught up in the tug of war between balancing costs and distributing equity of their companies. Although there are no fixed principles, diluting their equity stake is a concern for every founder because they are building their next unicorn in the making, and they are rightful to grow with the company.
To understand how equity dilution works, imagine the company as a piece of land. When you start your venture, only a few people are occupying this land (shareholders). As you bring on more investors, an advisor, and establish an ESOP pool, you have to share parts of the land, and your space on the land reduces as more people get added as shareholders. The reduction of your space/percentage of shareholding as a shareholder is termed as dilution of equity.
Infographic Illustration
Fundamentally, each company is made of 100% shares (remember the one whole of something is always 100%). Let’s understand this with an example to get clarity.
- 2 Founders viz. A and B are holding 5,000 shares each with 50% of ownership in the Company.
- An investor, C comes with an investment of 1Mn dollars considering the valuation of 3Mn dollars
Now have a look at the figures in below table to understand this quickly:
Here, the number of shares has been increased basis the ratio to post investment i.e. 25% (1Mn/4Mn). The investor can keep any ratio post investment basis the agreement.
We can understand that post investment round, the holding % of founders are getting diluted and their controlling interest has been reduced from the original scenario.
There are various types of dilution, including dilution of shares in a private company. It’s also important to know the equity dilution meaning and examples of equity dilution in startups.
There is no exact solution to how much equity to dilute; it depends on the stage of the business you are at. Too much dilution can be of concern to a future incoming investor and too little dilution concerns investors as they should have skin in the game. The ultimate goal is to grow the business. So even if the dilution numbers are skewed from the expected dilution you have in mind, the growth of the business is primary, and investment helps you get closer to that goal.
Pre-money valuation is the value of the company prior to receiving the investment amount. It is derived through various internationally accepted valuation methods like the discounted cash flow method. Investors offer equity based on pre-money valuation; however, the percentage sought is based on post-money valuation.
Understanding dilution and cap tables are pertinent metrics for fundraising and talking to investors. Founders often neglect it due to a lack of clarity of these concepts. A grasp on concepts like dilution and the cap table enables the founder to have better control of the startup equity. Want to learn more about startups and fundraising?
FAQs
Q: What is equity dilution?
A: Equity dilution is the reduction in existing shareholders’ equity ownership that occurs when additional shares are issued during a fundraising campaign or exercising of an option pool.
Q: What is share dilution?
A: Share dilution refers to the reduction in the ownership percentage of existing shareholders when additional shares are issued.
Q: When does dilution of information take place?
A: Dilution of information refers to the decrease in the quality and accuracy of information about a company due to the addition of new shareholders, which can happen during equity dilution.
Q: Is equity dilution good?
A: The answer depends on the perspective. From a founder’s point of view, diluting equity may be a necessary step to raise capital and grow the business. However, from an investor’s point of view, dilution of equity reduces the value of their stake in the company.
Q: How is equity dilution calculated?
A: The amount of equity dilution depends on the number of shares issued and the percentage of ownership of the existing shareholders.
Q: What is the effect of equity dilution?
A: The effect of equity dilution is that it reduces the percentage of ownership of existing shareholders, which can lead to a loss of control and influence over the company.
Q: What are the pros and cons of equity dilution?
A: The pros of equity dilution include raising capital and increasing the value of the company. The cons include a reduction in the percentage of ownership and control for existing shareholders.
Q: What is equity dilution in startup?
A: Equity dilution in a startup refers to the relatively common practice of issuing additional shares of stock to attract new investors or raise capital to fund the growth of the business.
Q: What is dilution in finance?
A: Dilution in finance refers to the reduction in the value of a share or stock due to the issuance of additional shares in the market.
Q: Is it legal for a company to dilute shares?
A: Yes, it is legal for a company to dilute shares as long as it follows the applicable regulations and obtains the necessary approvals from its shareholders.
Q: Is dilution good for stocks?
A: Dilution can be good or bad for stocks, depending on the circumstances. It may be good if the additional capital raised is invested in profitable projects that increase the value of the company. However, it may be bad if the dilution negatively affects the value of the existing shares.
Q: Why do companies dilute their shares?
A: Companies dilute their shares to raise capital for growth, acquisitions, debt repayment, or simply to maintain the financial health of the company.
Disclaimer:
The content of this article is for information purpose only and does not constitute advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point of time and prepared with due accuracy & reliability. Readers are requested to check and refer to relevant provisions of statute, latest judicial pronouncements, circulars, clarifications etc before acting on the basis of the above write up. The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that the Author / Treelife is not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof.
