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How Does Startup Stock Dilution Work?

lawtrades stock dilution spreadsheet

When it comes to startup fundraising, stock dilution is part and parcel of the game. To grow your startup, you are exchanging equity for capital, after all. However, excessive dilution can leave the founders and team with a disproportionately small share of the value that the startup realizes. It is therefore important to know exactly what stock dilution is, how it comes about, and how it should be managed. Ideally, you should know all of this before your first round of startup fundraising.

What is Dilution?

Stock dilution occurs when there is a decrease in your ownership as you issue new equity to investors. There are two different types of stock dilution.

The first is stock dilution in the narrow sense of the word. Here, the dilution in question is of your percentage ownership. For example, if you and a co-founder start out with 50% ownership in your startup’s equity, and you then sell 20% of your stock to an investor, you are each left with only 30% of the stock. In real terms, your percentage ownership has been decreased: there has been stock dilution.

The second type of stock dilution is dilution in a broader sense – a decrease in the economic value that your shares carry. This is sometimes referred to as economic dilution. Here, let’s assume that you keep 30% of the common stock in your startup, but a new investor gets favorable equity terms in exchange for his/her investment – for example, participation rights and liquidation preferences. This means that the value of the 30% common stock that you hold has decreased.

Stock Dilution and Valuation

A decrease in your percentage ownership of the company’s stock is, of course, neither good nor bad without taking valuation into account. For example: owning 50% of a company that is worth $2 million is exactly the same as owning 20% of a company that is worth $5 million. This is why startup founders are generally willing to hand over stock in their company – the company’s value, and therefore the value of their ownership, increases over the course of funding rounds.

The danger of stock dilution comes where you are giving up more value than the increased valuation offers. In other words, you shouldn’t be concerned with maximising your ownership percentage, but you should aim maximise the value of your ownership stake. This requires a keen understanding of your company’s potential value.

Avoiding Unnecessary Stock Dilution

There are several steps you can take to manage stock dilution and maximise the value of your ownership share.

First, be aware of all the sources of dilution, and make sure that stock dilution in these instances stay proportionate to the potential increase in your company’s value. In other words, in each of these instances: be aware that you are getting a smaller piece of the pie, and take care, therefore, that the pie increases enough to make your smaller piece worth the same (or even more).

Issuances of new preferred stock
Issuances of new common stock
Issuances of stock options
Issuances of warrants
Increases in the conversion rates of preferred to common shares
Issuance of convertible debt (this will be dilutive in the future at some point when the debt is converted)
Liquidation preferences
Participation rights
Cumulative dividends

Second, always remember to take tax implications into account. For example: stock option grants have potentially as much as a five fold higher tax burden associated with them than stock grants. When you do calculate the value of your ownership share, in other words, don’t forget to include tax implications in those calculations.

Third, limit the size of your option pool. Option pools are shares of stock kept aside for future employee stock option grants – it is created from, and directly impacts, the share value and ownership percentage of common stockholders – and therefore founders equity.

The size of the option pool should be considered carefully and negotiated fiercely. Here is why: the option pool is a percentage of the value of the company, rather than a percentage of the shares. In most cases, the pool represents the percentage of the post-closing, fully-diluted capitalization of the company that is available for future option grants. The size of the option pool is therefore critical. We discuss option pool negotiations elsewhere in this blog.

Finally, take care to have accurate valuations of your company. Valuations that are lower than your startup’s real value will lower the value of your ownership stake disproportionately.

How Much Stock Dilution To Expect?

There are industry standards that can be used as rules of thumb to ensure that you are not diluting your equity unduly. Generally, you can expect that founders stock will dilute by about 10%-25% during seed rounds; 25%-50% for Series A, and roughly 33% for Series B.

However, do not follow these guidelines blindly. Some startups can be much more capital efficient than the industry average, allowing them to get by with less dilution. Use these values as a point of departure, and then try to get as much out of your financing. Do as much as possible with as little as possible. Too many startups burn cash unnecessarily and sacrifice their future ownership percentage in the process.

Hire a Startup Attorney Today

Startups have options when it comes to fundraising for their new business. Attorneys providing legal fundraising services can advise you about the various benefits and liabilities of these financing options, helping you make an informed choice for your business. For companies who prefer to raise capital through equity, an experienced fundraising law attorney can help set up an equity financing raise.

Regardless of the method of fundraising you choose, a skilled attorney can be very helpful in providing you with the fundraising services you need to make your capital raise a success. Talk to one of our experts today!