When you add water to a glass that’s half-filled with cranberry juice, what happens? A couple of things. You increase the amount of liquid in the glass, and you dilute the potency of the juice. Though this may seem like an odd analogy to begin a discussion about equity, share dilution works in a similar way.
When a company dilutes its shares, it increases the number of its outstanding shares by issuing new shares of stock. But the ownership percentage of the company represented by the existing shares shrinks, and each of those shares loses a bit of its value. Just as adding water dilutes the potency of cranberry juice, issuing new shares dilutes the potency of pre-existing shares.
Share dilution, also known as stock dilution or equity dilution, can be a pretty complex topic for companies and shareholders to navigate—and juice metaphors will only get us so far. In this guide, we’ll review the basics of share dilution and discuss some common reasons shares become diluted. It’s important to note up top that share dilution isn’t necessarily bad for current shareholders, but it can have damaging effects if it isn’t done with a sound strategy to use the new shares in a way that increases the value of the company.
- What is share dilution?
- How shares can become diluted
- Is share dilution bad for existing shareholders?
- Stock dilution vs. stock splits: What’s the difference?
- How Pulley can help model equity dilution
What is share dilution?
The phenomenon known as share dilution happens when a company does something to increase its number of shares outstanding. Increasing the number of shares means decreasing, or diluting, the ownership stake represented by each individual share.
To really understand this process and why it matters, it’s helpful to step back and look at why a company would want or need to issue new shares in the first place.
A company may issue shares for a number of different reasons—for example, to raise money from new investors or to compensate employees. When we talk about a company’s shares outstanding, we’re talking about the total number of actual shares currently issued and held by the company’s stockholders. The more actual shares there are, the smaller percentage of an ownership stake each share represents.
Let’s take a look at a hypothetical example to illustrate how shares in a company can represent a percentage ownership stake in that company. We’ll use this example to demonstrate what happens when those shares are diluted.
A basic example of share dilution
Say a business has 1,000,000 shares outstanding. An early investor in that business owns 100,000 shares of the company, which represents a 10% ownership stake (10% of 1,000,000 is 100,000).
The company’s executives decide that they want to fast-track growth by raising additional capital from public investors, so they take the company public via an initial public offering (IPO). As part of this IPO, 1,000,000 new shares of stock are issued for public investors to purchase.
At this point, the company has 2,000,000 shares outstanding. The initial investor still owns 100,000 of those shares, but something interesting has happened. The investor’s ownership percentage in the company has actually shrunk from 10% to 5% (100,000 is 5% of 2,000,000). Without selling or buying any shares, the investor’s ownership stake in the company has been cut in half!
Does this mean that the dollar value of the investor’s stake in the company has decreased? Not necessarily. If the company’s profitability has soared and its value has grown, then a 5% stake in the company post-IPO might actually be worth more than a 10% stake in the company pre-IPO. But the issuance of new shares may lower the earnings per share and may reduce a stock’s price (at least in the short term), which is why many existing shareholders tend to not love stock dilution, as a rule.
Of course, whether share dilution is truly bad for existing shareholders is a bit more complicated. We’ll cover that topic in a bit, but first let’s take a look at some of the different reasons why share dilution occurs.
How shares can become diluted
The dirty little secret about share dilution is that, in many cases, it’s pretty inevitable. It’s not entirely realistic to expect a fast-growing company to attract new talent, raise capital, and grow its business without using the tool of issuing new stock.
The trick for most founders and founding teams is to be smart about equity dilution and not to get too gung-ho about giving away large chunks of their company in the early days. Having a strategy and a model for equity dilution is essential, because you can’t simply ask for part of your company back after you give it away. (Well, you can, but the answer will probably be no.)
A sound strategy starts with understanding the many ways in which shares can become diluted in the first place. Here are some of the most common causes of share dilution.
Exercising of employee stock options
An employee stock option gives an employee the right to buy a number of shares of company stock at a specific price. Stock options are often granted to employees as a key part of an overall compensation package, and they can help employers attract top talent to help grow their business.
If an employee decides to exercise their stock options, the options are converted into common shares when exercised. These shares increase the number of shares outstanding, and thus play a role in share dilution.
One important thing to note about employee stock options (and other forms of equity compensation, for that matter) is that they typically come with a vesting period that must pass before the options can be exercised. If an employee doesn’t satisfy the vesting requirements or leaves the company before their options vest, they won’t be able to exercise their options.
This—along with the fact that some employees may choose not to exercise options that have already vested—means that the effect of employee stock options on stock dilution may be somewhat unpredictable.
New stock issued to raise additional capital
If a company’s executives don’t have the money they need to pursue a new project or expansion, they may opt to issue new stock in an effort to raise new investment capital. How this works exactly may differ depending on whether the company is private or public.
For example, a private company may raise money in a priced funding round. This is a fundraising event in which external investors give a startup money that enables it to continue growing. In exchange for the money they put up, the investors receive new shares in the company that dilute existing shares. How much these shares end up diluting the existing shares may depend on a number of factors.
A public company at a later stage of its development may also raise money via a secondary offering (otherwise known as a follow-on public offering, or FPO). Secondary offerings happen after an initial public offering has already taken place, and they provide an additional influx of cash via the issuance of new shares. These new shares dilute existing shares and may have a negative impact on existing shareholders—especially if the company’s executives don’t have a rock-solid plan for using the new funds to power future growth and profitability.
Conversion of convertible securities
A startup company may opt to fund its growth in part by issuing convertible securities, such as SAFEs and convertible notes.
Though different convertible securities work in different ways, they essentially work as short-term, convertible debt instruments in which an investor loans a startup money in exchange for the ability to convert their investment into shares of company stock at a later date. When these securities convert, they convert into new shares that are added to the total number of shares outstanding—thus resulting in share dilution.
Acquisition of a new company
Share dilution may also occur when a company purchases or acquires a new company. This can happen for a number of different reasons. For example, a company may decide to issue new shares to the shareholders of the company it’s acquiring as a consideration of the deal.
Again, not all of these reasons are necessarily things you’d want to avoid as a founder, but it pays to think carefully about dilution and future ownership stakes before issuing new shares.
Is stock dilution bad for existing shareholders?
As we noted above, existing shareholders tend to balk at the words “stock dilution” because they interpret it as a signal that the value of their individual shares may decrease. And this is certainly a possibility.
In a vacuum, decreasing how much an investor owns of a thing decreases the value of what they own. One thing investors tend not to like about stock dilution is that it also causes the dilution of earnings per share (EPS), which is a helpful metric in evaluating a company’s profitability. In some cases, investors may be able to evaluate the impact of share dilution by looking at diluted earnings per share (diluted EPS), which calculates EPS assuming all convertible securities ultimately convert.
But when it comes to the impact of stock dilution, we’re not just talking about pure dollars. In many cases a large ownership stake in a company can come with voting rights and other shareholder rights, which can be impacted by share dilution as well. This is especially true for founders and early investors, who may see a large or majority stake in a company dwindle over time as their shares become more and more diluted.
With that said, share dilution does not necessarily have to be a bad thing for investors. As we outlined above, share dilution doesn’t just happen for no reason at all (or at least, it shouldn’t.) If a company has a strong reason for issuing new shares and/or uses the money raised to meaningfully improve its operations, then everybody can basically end up happy. After all, owning 10% of a sheet cake the size of a football field is better than owning 20% of a cupcake.
How anti-dilution provisions can protect existing shareholders
With all of that said, some investors are still able to protect the value of their shares using anti-dilution provisions. These protections are typically associated with preferred stock or convertible securities, and their goal is to ensure that an investor’s ownership stake in a company isn’t dramatically impacted by an instance of share dilution.
There are different types of anti-dilution provisions, but they generally work by allowing investors to convert certain securities into common stock at a price that protects their ownership stake in the company.
Stock dilution vs. stock splits: What’s the difference?
You may have heard of another process called a stock split, which also involves increasing the number of outstanding shares. But a stock split is not the same thing as stock dilution.
In a stock split, the existing shareholders typically maintain their same percentage of ownership. The share price drops, but there’s no dilution. For example, a stock split may see a single share valued at $100 split into two shares valued at $50. The investor who owns the first share would get two shares in the stock split, and their percentage of ownership would be unaffected.
Stock splits happen when a company wants to lower the price of its stock for a particular reason—perhaps to make the stock more accessible or attractive to a wider range of investors. In any case, these should not be confused with stock dilution.
How Pulley can help model equity dilution
We’ve reviewed the basics of share dilution, but the most important takeaway we’d like to leave you with is that this stuff is important. A typical company experiences multiple instances of stock dilution on its way from startup to IPO (and beyond), and how you model and manage each of these instances can make a big difference.
The good news? Pulley is here to help. Our advanced modeling features can help you model ownership at different stages of your startup’s growth trajectory, accounting for common terms like pro-ratas and option pool increases that may be negotiated in equity rounds.
You can even export our pro-forma to Excel and share the pro-forma with your investors to assure them that they’re receiving the correct number of shares.
Interested in learning more? Let’s chat.
