How to Avoid Unnecessary Stock Dilution During Business Startup Fundraising

Diluted shares pie chart dividend

Stock dilution is often unavoidable in the course of business startup fundraising. It is a necessary price to pay for growing your startup. However, excessive dilution can leave founders and early joiners with little reward for all their hard work. They key to avoiding this is to have a clear view of what stock dilution is, the various forms it can take, and how to minimize it throughout the business startup fundraising process. Here’s a short overview of everything you need to know about stock dilution.

 

What is Dilution?

In the context of fundraising, stock dilution occurs when there is a decrease in your ownership as you issue new equity to investors. There are two different forms 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. Economic dilution has taken place.

 

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.

 

  1. 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

 

  1. Take tax implications into account. For example: stock options 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.

 

  1. Limit the size of your option pool. We provide guidance on how to negotiate the size of the option pool elsewhere in this blog.

 

  1. Keep control over decisions to issue new stock – that way you keep control over dilution.

 

  1. 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.

 

Perhaps the most salient advice with regard to stock dilution is simply this: always be aware of it. Too many startups get so excited about the prospect of funding, and the market’s interest in its equity, that they forget to guard their ownership of that company. Investments and option grants necessarily dilutes equity. As such, both are double-edged swords. Always keep that in mind when making decisions that will affect your ownership. Better still: appoint a legal expert to help you optimize your ownership stake while growing your startup.

 

Startup Attorney

If you need further help understanding startup equity dilution, check out LawTrades to book a call with an experienced startup attorney. We offer affordable legal coverage designed to help you pay less and run your business with confidence.