In the midst of growing a company and all that entails, issues like equity dilution may seem too far off to worry about for many startup executives, something to worry about later. But when mishandled, the effects of equity dilution can be significant, especially for private venture capital-funded companies.
What is Equity Dilution?
At its most basic: as the number of new company shares increases, the ownership of existing shareholders decreases. Additional equity increases the number of shares outstanding, which in turn, dilutes the ownership percentage of existing investors.
Equity dilution can occur for a number of reasons, including:
- Raising a new round of preferred stock
- Granting stock options to employees
- The conversion of convertible notes
- An initial public offering (IPO)
Dilution can significantly shift important shareholder positions, including the value and earnings of shares, voting power, and ownership percentage.
Is Equity Dilution a Bad Thing?
Equity dilution must be bad for shareholders, then, right? Not necessarily. Consider: would you rather have 25% of $1 million, or 12.5% of $100 million? In order to grow that $1 million valuation into a $100 million valuation, that means spending money on expanding your business, which typically means taking on new investments.
Valuing Your Equity
There is a difference between dilution of ownership and dilution of value. Dilution of value occurs when an increase in shares causes a reduction in the price of stocks. The price after an increase in the number of shares, or the theoretical diluted price, can be calculated thus:
Theoretical Diluted Price =
- O = the original number of shares
- OP = the current share price
- N = the number of new shares to be issued
- IP = the issue price of the new shares
Common Stock & Preferred Stock
To add another caveat to the mix, it’s also important to understand the roles common and preferred stock play into dilution. To keep things relatively simple, the main difference between common and preferred stock is that preferred stock affords shareholders special rights over common stockholders. One of these rights being negotiation, which can include a provision in which preferred stockholders to a) convert their shares into common stock, or b) let them keep their preferred rights while participating in common stock.
Why would preferred shareholders want to convert to common stock? To get around the equity cap that comes with preferred shares.
Understanding Dilutive Terms
For investors, there are a number of terms that can have a higher dilutive effect, including the number of shares issued, liquidation preferences, the rate of conversion to common stock, participation rights and caps, and cumulative dividends. Let’s dig a little deeper into each of them.
Number of Shares
The connection between the number of shares issued and dilution of ownership is the most obvious – the more shares granted, the smaller the amount of ownership each share represents.
To determine an investors percentage of ownership, and how many shares they hold, you’ll need to know 1) the company’s value, and 2) how much they’re investing. By calculating your company’s pre- and post-money valuation, you can figure out how much dilution to anticipate.
Shareholders that have liquidation preference are at the front of the line in the event of liquidity. Most common is a 1x liquidation preference, which ensures, at a minimum, investors break even before common shareholders get anything. However, liquidation preferences with higher multiples on rate of return; i.e., 2x and 3x, can quickly become problematic. When preferred shareholders receive 2x or even 3x their initial investment, the odds that common shareholders end up with nothing get higher.
A 1x liquidation preference paired with a 1x conversion rate to common stock is normal, as investors are likely to at least make back their investment and they have the option, if the exit value is large enough, to convert to common stock.
Rate of Conversion to Common Stock
As we just briefly touched on, this term allows investors to convert their preferred share to common shares at a multiplied rate in the event of a distribution event. The dilutive effect of this term is best illustrated through an example:
- Shareholder A purchases 50 preferred shares in Company C for $1 a piece. Those shares are worth 5% of Company C and have a 1x liquidation preference.
- Company C exits, and Shareholder A’s shares reach their 1x liquidation preference at $50, so $50 is what Shareholder A walks away with.
- Shareholder B, who owns the same number of shares as Shareholder A, negotiated a 2x conversion rate to common stock in addition to the 1x liquidation preference. Instead of leaving the table with just their $50 investment, Shareholder B converts to common stock, doubling their shares and the percentage of the company they own.
If the value of the liquidity event is high enough, an investor that includes conversion to common stock rate in their term sheet stands a lot to gain.
Participation Rights & Caps
Participation rights give shareholders the best of both worlds. They get preferential terms of preferred shareholders, while also participating in common stock. When shareholders have participation rights, there is no need for them to convert their preferred shares into common shares.
Usually, participation rights come with a cap. This means that they get the advantages of preferred stock, but when they participate as common stock, there is a cap, usually around 2x or 3x their investment. When there is no cap, they can participate with common shares indefinitely, while still getting their preferred benefits.
The TLDR here is that caps on participation rights are necessary to prevent dilution.
The two types of cumulative dividends are Paid in Kind (PIK) and cash dividends, cash dividends being the most common. PIK dividends increase shares over time, and both PIK and cash dividends are paid out during an exit.
Cumulative dividends play a role in dilution because they generally will continue accruing until a liquidation event occurs, which should light a fire under founders to hit that liquidation event ASAP. That said, the effects of cumulative dividends are felt differently by different companies. For example, a small startup could feel the pinch from PIK dividends (which are paid out in shares), while a larger company may not feel the hurt from cumulative dividends with a reasonable interest rate.
Can Equity Dilution Be Prevented?
In short, no. When a business is growing, some amount of dilution is unavoidable, and really, as a founder, it’s not something you want to prevent. That said, the best way to prevent undue dilution is by keeping an organized cap table, knowing your terms, and planning equity decisions ahead of time where you can.
As an investor, something to watch out for is share dilution scams. In a fraudulent scenario, a company will arbitrarily issue massive numbers of shares. Done repeatedly, this will devalue shares to the point at which they are nearly worthless, bringing about significant losses for shareholders. Once share prices have hit rock bottom, the companies will reverse stock split, merging shares into fewer, more valuable shares, and then repeat the same scam over again.