What is Stock Dilution? A Guide to Protecting Your Ownership

You might be staring at a term sheet, realizing that the investment you desperately need comes with a hefty price: a significant chunk of your company. What's happening? It's called stock dilution, and it's something every startup founder and anyone holding employee stock options needs to understand.

As a startup founder, navigating equity and dilution can be overwhelming. This article will help you make sense of all the jargon and complex calculations. You'll also learn about Wise Business, an international business account helping you send and receive international payments safely and at low cost.

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What is Stock Dilution? What Happens When Shares are Diluted

Let's say your startup is like a delicious, freshly baked pizza. In the beginning, you, the founder, own the whole thing – 100%. That pizza represents the total ownership of your company, and we can divide it into slices, which we call shares.

Dividing Ownership

Now, you realize you need some help to scale your business. You might bring in an investor who, naturally, wants a piece of the pie – a slice of your pizza, so to speak.

To give them that slice, you have to cut the pizza into more slices. You're not magically making the pizza any bigger — you're just dividing it up differently. That, in a nutshell, is stock dilution.

A Simple Example

Here's a simple example. Let's say you started with 100 shares (100 slices). You decide to issue 20 new shares to your investor.

Now, 120 total shares are floating around. Your original 100 shares, which used to represent the entire company, now only represent 83.3% (100 / 120).

You still have the same number of shares, but each share represents a smaller percentage of the whole company.

Key Terms:
Shares Outstanding: This is simply the total number of shares your company has issued – all the slices of your pizza, regardless of who owns them.
Equity: Think of this as ownership in the company. It's your stake.
Percentage Ownership: It's the number of shares you own divided by the total number of shares outstanding, multiplied by 100. This tells you how much of the company you actually control.
Valuation: Valuation is what your company is worth – the price of the whole pizza.

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Why Stock Dilution Happens

So, why does dilution even happen? The main reason is that companies issue new shares to raise capital – that's the money they need to keep the lights on, develop their product, and, hopefully, grow like crazy. This is known as startup equity dilution.

It's a trade-off: you give up a little bit of your ownership in exchange for the resources you need to make your company more valuable in the long run.

Types of Stock Dilution

Stock dilution means increasing the number of shares, which in turn reduces the ownership percentage of everyone who already owns shares (known as ownership dilution).

But it's not always as straightforward as just issuing new shares to investors. There are a few different ways this can happen.

Stock Dilution Type	Stock Dilution Description
Fundraising (Primary Dilution)	The most common type of dilution startup founders run into is called primary dilution. This happens when the company creates and issues brand new shares to investors to increase capital. That fresh infusion of money is essential, directly increasing the total number of shares while diluting the ownership of existing shareholders.
Employee Stock Options (Option Pool Dilution)	Another big source of dilution comes from creating or expanding your employee stock option pool. This is a pool of shares set aside specifically for your team. While these shares aren't given to investors, they do represent potential future shares, and that potential impacts everyone's ownership. Investors almost always want to see an option pool in place – it's a key way to attract and keep top talent. The trick is to be smart about how big you make that pool.
Selling Existing Shares (Secondary Dilution)	You might also hear about secondary dilution. This is when existing shareholders (that could be you, your co-founders, or early employees) sell some of their shares to new investors. This doesn't dilute the overall ownership percentages because no new shares are created. It's like swapping slices of pizza – the total number of slices stays the same, but who owns which slice changes. This tends to happen more in later-stage companies, not so much when you're just starting.
Future Shares (Convertible Securities)	Convertible securities like SAFEs (Simple Agreements for Future Equity) and convertible notes are financial tools that eventually convert into equity. They do not grant ownership immediately but do eventually convert into shares. Convertible securities like SAFEs (Simple Agreements for Future Equity) and convertible notes are financial tools that eventually convert into equity. They do not grant ownership immediately but do eventually convert into shares. Convertible securities represent future dilution that will impact the ownership percentage.

The Math Behind Stock Dilution

Pre-Money vs. Post-Money Valuation

Understanding the difference between pre-money and post-money valuation is essential in evaluating a funding round. This distinction can have an impact on how much of the company you and founding employees own.

Valuation Type	Definition
Pre-Money Valuation – What You're Worth Before the Cash	Think of pre-money valuation as the agreed-upon value of your company before the new investment comes in. It's like saying, "Okay, based on everything we've built so far, our 'pizza' is worth this much."
Post-Money Valuation – What You're Worth After the Cash	Post-money valuation is the value of your company after the investment. To calculate: add the investment amount to the pre-money valuation. Post-Money Valuation = Pre-Money Valuation + Investment Amount.

A Practical Example

For example, an investor offers you $1 million at a $4 million pre-money valuation. That means after they put in their money, your company will be worth $5 million (that's the post-money valuation).

Their $1 million buys them 20% of the company ($1M / $5M), leaving you, the founder(s), with the remaining 80%.

Now, let's flip it around.

Imagine the same $1 million investment, but this time it's at a $4 million post-money valuation. TThat investor's $1 million buys them 25% of the company ($1M / $4M), leaving you with only 75%.

That seemingly small change in how the valuation is described – pre-money vs. post-money – makes a big difference to your ownership stake.

The Stock Dilution Percentage Formula

The basic formula for figuring out the dilution percentage:

Dilution Percentage = (New Shares Issued / (Original Shares + New Shares)) * 100

Let's use our first example again (the $4 million pre-money valuation). Let's say you had 8 million shares outstanding before the investment. The $1 million investment at a $5 million post-money valuation means the investor gets 2 million new shares ($1M / ($5M / 10M total shares)). So, the dilution percentage is:

(2,000,000 / (8,000,000 + 2,000,000)) * 100 = 20%

Fully Diluted Shares

Fully diluted shares outstanding, this include the shares currently available, as well as any shares that can be issued in the future—employee stock options, warrants, or the convertible securities mentioned earlier.

Investors often look at the fully diluted share count because it provides a comprehensive ownership percentages overview. This represents the maximum potential dilution.

By understanding these key calculations – pre-money vs. post-money valuation, dilution percentage, and fully diluted shares – you'll be in a much stronger position to analyze funding offers and understand their impact on your ownership.

Convertible Securities and Dilution (SAFEs, Notes)

Convertible securities, like SAFEs (Simple Agreements for Future Equity) and convertible notes, are popular tools for early-stage startup funding. They're a way for investors to put money in now, with the agreement that it will turn into equity later, usually when you do a priced round.

For startups, equity dilution does not yield results immediately—it occurs when SAFEs or convertible notes convert into shares.

SAFEs (Simple Agreement for Future Equity)

SAFEs are essentially a contract that lets an investor buy shares in a future-priced round. They're often used because they're simpler and faster to get done than a traditional equity round.

However, the terms of the SAFE, especially the valuation cap and any discount, can have a significant impact on how much dilution you experience when the SAFE finally converts into equity.

Convertible Notes – Debt That Morphs into Equity

Convertible notes are technically debt. They come with an interest rate and a maturity date, just like a loan. But instead of being paid back in cash, they convert into equity at a future funding round.

The interest rate, maturity date, valuation cap (if there is one), and any discount all affect how many shares the noteholder gets when the conversion happens – and that directly impacts your dilution.

Pro Rata Rights

Pro rata is Latin for "in proportion." It's essential when working out dilution and securing investment. It’s a right given in a contract allowing investors to keep their company ownership.

Good" Dilution vs. "Bad" Dilution — Growth vs. Control

For founders, the thought of stock dilution can be scary. You've built this company from the ground up and the idea of giving up any piece of it can be tough. It's important to acknowledge that feeling.

Trading Capital for Growth

But dilution isn't always a bad thing. In fact, it's often a necessary part of getting the funding needed to scale up.

It functions as a trade-off: you're giving up a portion of your ownership in exchange for the resources to expand, hire the best people, develop your product, and reach more customers.

"Good" Dilution is When a Smaller Slice is Worth More

"Good" dilution is what happens when you raise money at a higher valuation than in previous rounds. While the ownership percentage goes down, the overall value of r shares goes up because the company is now worth more.

It's like owning a smaller slice of a much, much bigger pie – that smaller slice can actually be worth more than a bigger slice of a smaller pie.

In fact, research shows that the median seed-stage founder owned 56% of their company at exit ¹ . This highlights how a founder's stake can evolve, and often decrease, over time through multiple funding rounds, even with "good" dilution.

"Bad" Dilution

"Bad" dilution, on the other hand, is what happens when money is raised at a lower valuation than before – this is what's called a "down round." Down rounds reduce both your ownership percentage and the value of your shares.

Bad dilution can also serve as a signal to investors that the company is struggling, which can make it harder to raise more money in the future. It’s worth noting that the goal isn't to avoid dilution but to ultimately grow.

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Minimizing Dilution — Strategies for Founders

Please note, this section is for informational purposes only and is not financial or legal advice.

Every startup is different, and the best approach for your company will depend on a range of factors. Always, consult with experienced legal and financial professionals before making any decisions around fundraising or equity.

That said, let’s break down some strategies addressing how to prevent share dilution for your startup.

1. Negotiate Your Valuation

One of the best ways to minimize dilution is to negotiate the highest possible valuation for your company that you can realistically justify. The higher the valuation, the less equity you'll have to give up for the same amount of investment.

Do your homework: research comparable companies, prepare rock-solid financial projections, and be ready to confidently explain why your company is worth what you're asking for.

2. Think Carefully About Funding Rounds

The timing and size of funding rounds have a big impact on dilution. Raising too much capital too early, when valuation is still low, can mean giving up a huge chunk of the company.

Think about smaller, more frequent rounds, raising just enough to reach key milestones that will increase your valuation for the next round.

3. Explore Alternative Funding Options

Equity financing (selling shares) is common, but it's not the only way to get funding. Consider venture debt, revenue-based financing, or even bootstrapping (using your own resources and revenue) as viable alternatives.

These options might involve less dilution, or even no dilution at all, but they come with their own set of pros and cons.

4. Keep Your Team in the Loop

If you have employees with stock options, be open and honest with them about dilution. Explain how it works and how it might affect the value of their options. Being transparent builds trust and helps everyone understand what's at stake.

5. Limit Early Borrowing

Try to limit your borrowing, especially in the early stages. This is the time when your business is generally worth the least, meaning any equity you give up will be more dilutive than it would be later on.

If you can bootstrap or find alternative funding sources initially, you can potentially preserve more of your ownership.

6. Borrow Funds Only When Absolutely Necessary

Only take on funds when you absolutely need the capital for growth or operations. Don't borrow money just for the sake of having it, or because it's offered to you.

Each time you raise capital through equity or convertible instruments, your shares, and those of your existing shareholders, will be diluted.

7. Have a Small(ish) Option Pool

While a stock option pool is essential for attracting and retaining talent, be mindful of its size. Dilution can be managed by keeping the option pool relatively small, especially in the early rounds.

You can always expand it later as needed, but you can't take shares back once they've been allocated. The fewer shares out there, the better.

Dilution – Understand It, Manage It, Don't Fear It

Stock dilution is a common part of the startup journey points to remember:

• Dilution happens when new shares are issued, reducing the ownership percentage of existing shareholders.
• It's often a necessary trade-off for securing the funding you need to grow.
• "Good" dilution (at a higher valuation) can be beneficial, while "bad" dilution (at a lower valuation) is detrimental.
• Take control of your equity by always analyzing, reviewing, and seeking guidance from legal and financial experts.

Don't let the complexities of stock dilution intimidate you. Arm yourself with knowledge, seek expert advice, and make informed decisions – that's the key to navigating the world of startup finance with confidence.

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Sources:

1. Carta Equity Research