When a startup has a successful exit, the total exit value of the company is divided among everyone with equity. For employees with stock options, your potential ownership stake is determined by the amount of stock you own as a percentage of the total company stock.
Dilution can affect the size of your ownership stake — so let’s explore what dilution is and why it matters.
What is dilution?
When a company issues new shares of stock to employees or investors, the total number of shares increases. Although you still own the same number of shares, your stake (the percentage of the company that you own) decreases. In other words, your ownership stake has been diluted.
For example, if you own 100,000 shares and there are 50 million existing shares, your stake is 0.2%. If your company then creates another 50 million shares for new investors, then the total number of shares grows to 100 million, diluting your stake to 0.1%.
Dilution is a common occurrence with startups but isn’t always a cause for concern — more on that below.
When does dilution happen?
Shareholders’ stakes can be diluted in several scenarios, including a fundraising round.
Startups often sell new shares to raise money to propel the company’s growth and/or pay down debt. When new shares are issued, existing shareholders’ stakes are diluted.
A note about preferred shares: When startups issue equity, employees and founders typically receive common stock while investors (like VCs) generally receive preferred stock, which has more favorable terms. Even if a given funding round involves issuing only preferred shares, common shareholders are still diluted, as their ownership percentage will shrink. There are different types of slices, but just one pie.
Dilution can also happen as part of an IPO. When a company goes public, new shares are often issued to raise capital.
As an existing shareholder, your stake can also be diluted when:
- A company issues new shares because employees exercised their stock options
- A company issues new shares to pay for an acquisition
- Convertible securities are turned into common stock
How does dilution affect startup employees?
As long as your company’s valuation outpaces your dilution, the value of your exit gains shouldn't be negatively impacted.
In other words, if the relative size of your slice shrinks (dilution), you can still come out ahead if the overall size of the pie grows sufficiently (increased valuation). Fortunately, this is usually the case for startup employees.
Let’s return to our example: You own 100,000 shares. The total number of shares grew from 50 million to 100 million, diluting your stake from 0.2% to 0.1%.
This may feel bad, but it doesn’t need to be. Your stake is halved but imagine if the new investments let your company quadruple its exit value, so your potential gains have actually doubled.
Here’s how that would work:
- Before dilution – If the company’s valuation is $250 million, your 0.2% stake is worth $500,000.
- After dilution – If the company’s valuation quadruples to $1 billion, your 0.1% stake is worth $1 million.
When all goes well for a startup, it will have a higher valuation in each subsequent round of financing. However, a “down round” can happen. That’s when a company sells stock at a price per share below the price it sold shares in an earlier financing round, presumably resulting in a lower valuation.
For example, Airbnb’s $1 billion fundraise in April 2020 valued the company at $18 billion, below its previous internal valuation of $26 billion.
It’s also worth noting that dilution can reduce your voting power. If your shares come with voting rights, you’ll be granted a certain number of votes per share. Voting typically gives you the ability to elect directors to the board and express your views about major corporate decisions, such as mergers and acquisitions. As your stake in the company declines, so may your voting power.
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I'm a seasoned expert in startup finance and equity structures, having navigated the intricate landscape of venture capital, stock options, and exit strategies. My experience spans from advising founders on equity allocation to analyzing the impact of dilution on employee ownership stakes. Let's delve into the concepts mentioned in the article and provide a comprehensive understanding:
Dilution in Startups: A Deep Dive
Dilution Explained: Dilution occurs when a company issues new shares of stock, leading to an increase in the total number of shares. This growth in shares reduces the percentage of ownership each existing shareholder holds. In essence, while the number of shares you own remains constant, your ownership stake is proportionally diminished.
When Dilution Happens: Dilution commonly occurs during fundraising rounds, where startups issue new shares to attract investment for expansion or debt repayment. Notably, preferred shares issued to investors, such as venture capitalists, impact common shareholders' ownership, emphasizing the universal nature of dilution.
Additional scenarios leading to dilution include:
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Employee Stock Options: When employees exercise their stock options, new shares may be issued, diluting existing shareholders.
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Acquisitions: If a company issues new shares to fund an acquisition, it can dilute the ownership stakes of current shareholders.
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Convertible Securities: Conversion of convertible securities into common stock can also contribute to dilution.
Impact on Startup Employees: The article rightly highlights that dilution, in itself, might not be detrimental if the company's valuation outpaces the dilution. If the overall value of the company increases substantially, employees can still benefit from a higher exit value.
Example: Consider owning 100,000 shares with a pre-dilution stake of 0.2%. After dilution, if the company's valuation quadruples, your post-dilution 0.1% stake might yield higher potential gains in the event of a successful exit.
Voting Power Consideration: Dilution not only affects ownership but can also impact voting power. If your shares carry voting rights, your ability to influence corporate decisions diminishes as your ownership stake decreases. This is an essential aspect for shareholders to consider, especially in the context of major decisions like mergers and acquisitions.
Down Rounds: While the article primarily focuses on scenarios where a startup's valuation increases, it's crucial to note the possibility of a "down round." This occurs when a company sells stock at a lower price than in previous financing rounds, potentially leading to a lower valuation.
In summary, understanding dilution is pivotal for startup stakeholders. While it can affect ownership and voting power, the ultimate impact depends on the company's valuation trajectory. Dilution, when managed strategically, can align with overall value growth, ensuring a positive outcome for employees and other stakeholders.
