Dilution is a term that often strikes fear into the hearts of first-time founders. It refers to the decrease in ownership percentage of existing shareholders when a company issues new stock. In simple terms, it means your slice of the pie gets smaller.
This is a mathematical inevitability of raising venture capital. Unless you bootstrap your company entirely with your own savings and revenue, you will face dilution. Every time you bring in outside money, you must print new shares to give to those investors. As the total number of shares increases, the percentage represented by your original shares decreases.
It is important to understand that dilution is not inherently negative. It is the price you pay for capital. The goal is that the capital you receive will grow the total value of the company fast enough to offset the reduction in your ownership percentage.
The Mechanics of Issuing Shares
#Many founders misunderstand how investment works mechanically. They often think they are selling their own personal shares to an investor. This is rarely the case in early-stage fundraising.
Instead, the company creates, or issues, new shares.
Imagine a company has 1,000 shares total, and you own all of them. You own 100 percent. An investor wants to buy 20 percent of the company. You do not give them 200 of your shares. The company issues 250 new shares to the investor.
Now there are 1,250 shares total. You still own your original 1,000 shares, but 1,000 divided by 1,250 is 80 percent. You have been diluted by 20 percent. The number of shares you own stayed the same, but the denominator changed.
The Value Trade Off
#The most common comparison regarding dilution is the relationship between percentage ownership and the total enterprise value. This is often described using the “pie” analogy.
Would you rather own 100 percent of a grape or 10 percent of a watermelon?
Dilution is the process of trading a large percentage of a small company for a smaller percentage of a much larger company. If you own 100 percent of a company worth nothing, your equity is worthless. If you own 10 percent of a company worth one billion dollars, you are wealthy.
Founders must constantly weigh this trade off. The question is not how much dilution you are taking, but whether the cash you are receiving will increase the value of your remaining stake by more than the percentage you gave up.
The Option Pool Scenario
#One specific scenario where founders often face unexpected dilution is during the creation of an employee option pool. Investors will typically require a startup to set aside 10 to 20 percent of the company for future employees before they invest.
This is usually done “pre-money,” meaning the dilution for this pool comes entirely out of the founder’s stake, not the investor’s stake. If you are negotiating a term sheet, understanding who takes the dilution hit for the option pool is a critical point of leverage.
Control vs Economics
#Dilution affects two things: economics and control.
Financial dilution impacts how much money you make when you exit. Governance dilution impacts your ability to make decisions. If you sell more than 50 percent of the voting shares, you technically lose control of the board and the company.
Founders need to track both. It is possible to have economic dilution without losing control if you utilize different classes of stock with different voting rights, though this is less common in early-stage startups.