No matter what funding round an investor decides to invest in, subsequent funding rounds can impact an investment. Each funding round a startup goes through after an investment is made has the potential to reduce the ownership stake, slowly chipping away at the slice of the pie. However, there are measures investors can take and anti-dilution provisions to consider to help mitigate the effects of dilution. In this blog, we’ll explore what dilution is, the potential implications, and navigating ownership dilution in startup investments.

Ownership Dilution in Startup Investments

At its core, dilution refers to the reduction in an investor’s ownership percentage that occurs when a company issues new shares, either through a funding round or other stock option programs. Each new share issued can dilute the value of the existing shares.

A simple way to look at this is by visualizing a pizza. In the first funding round, perhaps the pizza is split into 8 slices. After the second round of funding, now that pizza is cut into 16 slices. Each of the 16 is now smaller than the original 8 slices.

Let’s look at an example to illustrate how this could potentially work with equity shares

Seed Funding

A pizza company (PC) is raising $200,000 in seed funding. The company has authorized 1,000,000 shares and decides to sell 20% of the company, or 200,000 shares, in exchange for equity at $1 a share. This leaves 800,000 shares, 80% of the company outstanding. You, an investor, decide to invest $10,000 into PC for 10,000 shares. Since the company authorized 1,000,000 shares, you would own 1% of the company (dividing 10,000 purchased shares by 1,000,000 authorized shares and multiplying by 100 to convert to a percentage).

Series A Funding

The same company, PC, decides to raise a Series A round at a later date. The company decides to authorize an additional 200,000 shares this round, bringing the total number of authorized shares to 1,200,000. After the seed funding round, you owned 1% of PC with your 10,000 shares. After the Series A round, your 10,000 shares are only equal to about 0.83% of the company’s 1,200,000 total shares.

This dilution effect can compound over multiple funding rounds, gradually eroding an early investor’s equity position. And it’s not just new investors that can cause dilution – employee stock option pools, convertible notes, and other equity grants can also contribute to diluting the pie.

The Risks of Dilution

Dilution isn’t just an abstract financial concept – it can have real implications for early investors. Here are some of the key risks to be aware of:

1. Reduced Control: As your ownership stake decreases, so does the ability for an investor to influence the company’s strategic direction and key decisions. This can be a hurdle if the new investors have different goals or priorities.
2. Diminished Returns: If the startup is successful and ends up being acquired or going public, the eventual payout an investor receives could be a smaller percentage of the overall valuation.
3. Liquidity Challenges: Some investors rely on their startup equity as a path to liquidity. Excessive dilution can make it more difficult to cash out shares, especially if an investor no longer holds a meaningful ownership percentage.
4. Misalignment of Incentives: When new investors come in, their interests may not perfectly align with those of an early backer. This can lead to conflicts and suboptimal outcomes for the company.

Mitigating the Risks

While dilution can be an unavoidable part of the startup funding lifecycle, there are steps investors can take to help mitigate the risks. Here are some key provisions to consider negotiating:

1. Anti-Dilution Rights:

Anti-dilution rights can give investors the right to participate in future funding rounds, allowing them to maintain their ownership percentage by purchasing additional shares. There are a few different types of anti-dilution rights, each with their own nuances:

• Preemptive Rights: Allows existing shareholders to buy a certain amount of new shares before they are offered to others.
• Pro Rata Rights: Allows investors to purchase a pro rata share of any future funding rounds.
• Weighted Average Anti-Dilution: Adjusts the conversion price of preferred shares if the new round is at a lower valuation.

2. Liquidation Preferences:

This provision dictates the order in which shareholders get paid out in the event of a liquidity event, such as an acquisition or IPO. A senior liquidation preference means those investors will get paid out first, before common shareholders and junior preferred investors. However, liquidation preferences are only relevant if a liquidation event occurs, which does not always occur.

It’s important to note that the specific rights and provisions an investor may be able to secure will depend on the stage of the company, the competitive landscape, and what is negotiated with the issuer. The earlier the investment is made, the more influence an investor may have in shaping these protective measures.

Striking the Right Balance

Ultimately, the goal is to find the right balance between mitigating the dilution of the investment and enabling the company to continue growing and succeed. Overly restrictive terms could hinder the startup’s ability to raise capital and execute on its vision.

It can be important to work collaboratively with the founders and other investors to craft an agreement that addresses concerns around dilution, while still allowing the company the flexibility it needs to thrive. Open communication, mutual understanding, and a shared commitment to the company’s long-term success can be important.

Final Thoughts

Dilution is an unavoidable part of startup investing, but it doesn’t have to be a source of undue anxiety. By understanding the implications, negotiating protective provisions, and maintaining a collaborative mindset, investors can help mitigate dilution of their investments while supporting the company’s growth.

Are you looking to invest in startups? Sign up for a MicroVentures account to start investing!

Want to learn more about resources for investors? Check out the following MicroVentures blogs to learn more:

• Understanding Secondary Transactions: Right of First Refusal
• Assigning Order: What are Liquidation Preferences?
• Keeping a Clean Cap Table: Understanding Crowd Notes
• What’s It Worth? Navigating Inflated Startup Valuations
• Tale of Two Metrics: Market Cap and Market Value

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.