Stock Dilution in Startup Investing — Good or Bad?
So, you have taken the plunge and invested in a startup and received your stock. But what happens in the future when new investors come in? It is important for you to understand stock dilution.
What is Stock Dilution?
Stock dilution happens when a company issues additional stock.
Imagine you know an amazing pastry chef who is famous for her pecan pie but does not have enough money to bake her next batch. The chef proposes a deal with you — if you promise to pay for 30% of the ingredients, she agrees to bake a pie that she will cut into ten slices and agrees that you can eat three of those slices. Simple, right? You pay for 30% of what it takes to make the pie and in return, you get to eat 30% of the end product.
But soon after your agreement with the chef, a storm hits Mexico that wipes out half the national pecan crop, driving up the cost of pecans. The chef realizes she now needs more money to buy the ingredients, so makes an additional deal with five new customers, promising them one slice each once the baking is done. So, this means the finished pie will now be cut into 15 slices. You will still get to eat three slices, but instead of this being 30% of the whole pie (3/10), it is now only 20% of the pie (3/15).
Stock dilution in a company works a bit the same way as the pecan pie example. Let us say you invest in the seed round of a startup that has issued 10m shares at a valuation of $0.10 per share, which means the company is valued at $1m. You invest $100k and purchase 1m shares, which means you own 10% of the company. Time moves on, the company grows and needs more funds to expand, so decides to go to market again and do a Series A round of capital raising. To enable this, the company issues another 5m shares, increasing the total number of shares to 15m. Once these new shares are sold, you still own your original 1m shares but your percentage ownership of the company has now reduced to 6.7%.
Dilution is a fact of life when investing in startups. It comes with growth. When successful companies grow, it is common for them to raise capital in multiple funding rounds. Each funding round involves issuing more shares, which consequently results in dilution. But as noted above, a lower percentage ownership of a more valuable company could potentially be worth more.
Understanding Stock Dilution
It is important to realize that stock dilution is not necessarily a bad thing — any new investment should aim to increase the value of the whole, so that even if your percentage ownership goes down, the pie should get bigger so that your share of the pie could actually be worth more. Note this is not always the case, so it is vital to understand the implications of total value (more on that later).
To help understand the principles of stock dilution, let us look at some visuals. The pie charts shown below represent the share of a company based on the example described above, i.e. a company raises a Series Seed round with 10m shares, with two founders having 4m shares each, a stock options pool of 1m shares and a single early investor who puts in $100k for 1m shares. Then, a further 5m shares are issued in a Series A round, which are all taken by a single investor. The total number of outstanding shares now goes up to 15M shares. The pie charts show that the original investor in the Series Seed round who purchased 10% of the company has had their ownership reduced to a smaller slice of the pie in the Series A round, with their stake going down to 6.7% (i.e., 1M shares out of a total of 15M shares).
You can find more information on dilution in the article on Medium entitled Fundraising 101: What’s the Real Value of a Startup? along with some additional information on valuing startups.
You can also find out more information about stock dilution in this article on Capitalization Tables.
Company Share Structure
When evaluating an opportunity to invest in a startup, it is important to understand their shareholding structure. When a startup is formed, the total number of shares the company can create is defined in the articles of incorporation, known as Authorized Shares. This figure is decided upon by the company founders.
Once the company is established, some of the Authorized Shares are issued to people involved in the company, such as the founders — these shares are known as Issued Shares or Outstanding Shares.
Startups usually hold in reserve a number of Authorized Shares to allocate to future investors and employee stock options to incentivize staff (these provide the option holder with a right to purchase shares at an agreed price at a future date).
It is also important to understand there are different types of stock with different rights attached to them. You can find out more about these types of stock in the article Preferred Stock vs. Common Stock in Startups.
Other Types of Dilution
While this article is focused on stock dilution relating to startups, dilution can also be something to watch out for in a company that is publicly traded, after it has gone to an Initial Public Offering (IPO) where a company offers its shares for sale to members of the public for the first time.
Sometimes, a public company might decide to raise additional capital by issuing more shares for sale in a secondary offering, sometimes called a follow-on offering. This results in stock dilution for existing shareholders.
Another way that stock dilution can occur is if a company offers stock warrants, which gives the holder the right to purchase stock from the company at a particular price at a particular time and requires the company to issue new shares to fulfill the warrant when it is exercised.
Common Causes of Stock Dilution
Dilution is a fact of life when investing in startups. It comes with growth. When successful companies grow, it is common for them to raise capital in multiple funding rounds. Each funding round involves issuing more shares, which consequently results in dilution. But as noted above, a lower percentage ownership of a more valuable company could potentially be worth more.
In addition to funding rounds, another potential cause of dilution is an expansion of an employee stock option plan, where a company might issue more shares for employee stock options to attract more key staff.
While uncommon and not an ideal scenario, another potential cause of dilution is an expansion of founder’s stock, where additional shares are issued to founders after their initial allocation.
While it is the general intention that a new share issue should achieve a net increase in value, sometimes a company’s performance and financial position requires a capital raise in what is called a “down-round” where shares are offered at a price lower than in a previous funding round. This might occur when a company needs more capital simply to keep operating rather than growing, which negatively impacts the valuation. This situation has the double impact of dilution but also decreased overall value.
Note that most dilution events require acceptance by a majority of shareholders voting by class.
How to Calculate Stock Dilution
The math is relatively straightforward to calculate stock dilution, using some division and percentage calculations of the before and after situation of the dilution event, such as a capital raise in a new funding round.
To calculate your percentage ownership before the dilution event, simply divide the number of shares you own by the total number of fully diluted shares at the time of your investment. Fully diluted shares is the total number of shares including issued shares as well as those that would be included if all options and warrants were exercised. Then to calculate your percentage ownership after the dilution event, use the increased total number of fully diluted shares in your calculation.
The following example shows the calculations based on an initial purchase of 1.5m shares out of an original 10m fully diluted shares, followed by a subsequent funding round where an additional 5m shares were created and issued.
- Percentage ownership from original investment = 1.5m ÷ 10m = 15%
- Percentage ownership after new share issue = 1.5m ÷ 15m = 10%
- Dilution = (15% — 10%)/15% = -33%
Is Stock Dilution Good or Bad?
As noted above, stock dilution comes with the territory when investing in startups because it is a result of growth. The question of whether dilution is good or bad comes down to total value rather than percentage. If the value of your shares has increased by enough to offset the diluted percentage ownership, then you’re ahead. If not, you are behind.
The total value of your holding in a company is simply calculated by the number of shares you own multiplied by whatever the share price is at that moment in time. Let’s continue the example above to look at one good scenario and one bad, based on a share price of $0.10 for the original investment.
- Original investment: 10m fully diluted shares at $0.10 each = $1m total valuation. Investor purchases 1.5m shares at $0.10 each = $150k investment.
- Scenario 1 (good): Subsequent funding round with 5m new shares issued at $0.15 each. Total = 15m fully diluted shares at $0.15 each = $2.25m total valuation. Value of original investment is now 1.5m shares at $0.15 each = $225k.
- Scenario 2 (bad): Subsequent funding round with 5m new shares issued at $0.09 each (a down-round). Total = 15m fully diluted shares at $0.09 each = $1.35m total valuation. Value of original investment is now 1.5m shares at $0.09 each = $135k.
Mitigating the Effects of Dilution — What Should Investors Look For?
1 Source: National Venture Capital Association model legal docs for Term Sheet
It is possible to mitigate the effects of dilution via anti-dilution provisions (clauses) in a Term Sheet . To help build your understanding of a term sheet, you can download a template from organizations such as Series Seed or the National Venture Capital Association (NVCA). Shown below is a screenshot from the NVCA template, highlighting their anti-dilution clause.
Anti-dilution provisions work by adjusting the conversion price at which preferred stock converts to common stock, which protects the holders of preferred stock (refer to this Preferred Stock vs. Common Stock in Startups article for more information on types of stock).
There are two types of anti-dilution provision:
- Partial protection, often called the “weighted average” is most common and is often included in term sheets.
- Complete protection, also called “full ratchet”, although this is not commonly used.
The Partial anti-dilution provision is calculated using a weighted average calculation to obtain the revised conversion price, as follows:
P2 = P1 x (N1 + $) / (N1 + N2)
P1 = the old share price for conversion
P2 = the new share price for conversion
N1 = the total number of shares before a new issue
N2 = number of new shares issued
$ = the total payment received by the company for the new issue
An example of the above calculation is shown below, based on some hypothetical numbers:
N1 = 10,000,000
$ = $4,000,000 (i.e. the share price for the new issue is $4m / 5m shares = $0.80 per share)
P2 = 1*(10,000,000+4,000,000)/(10,000,000+5,000,000)
= $0.93 per share
With a Complete anti-dilution provision, the price at which conversion of existing preferred shares occurs is reduced to the price paid for new shares in later rounds. For example, if an early investor paid $1.20 per share and a subsequent round were priced at $0.90, the investor’s conversion price would go down to $0.90 per share.
Is the Stock Dilution Worth Accepting a New Investment?
In many cases, the individual investor is a minority owner and cannot influence the terms of a new financing. The charters of most companies require a majority of each stock class to approve new financings. If the majority of stock-holders in a specific class vote against a new financing it could get scuttled. Practically speaking, in most cases, a handful of the largest stock holders within a class determine the outcome of the vote. These largest shareholders hold the power to sway the vote. In many instances, the largest shareholders in a class are venture capital firms, and they frequently exercise their power, often asking startups to obtain better terms.
All this said, the question arises — should individual stockholders vote in favor of a dilutive financing? As discussed above, many times their vote will not sway the outcome. But if it does, it is worth considering the following: If there is a net increase in value, then it certainly makes sense to accept a new investment that causes stock dilution. An alternative view is that it still makes sense to accept dilution even when there is a net decrease in value. The reasoning is — investors should remain focused on the longer term prospects of the startup, the reason why they invested in the first place. If investors believe that in the medium-to-long term, the company has good prospects, then it is worth accepting dilution in the short term.
Bottom Line
Stock dilution is a common occurrence when investing in startups. It is important to look beyond the narrow view of stock dilution and consider the investment with a wide perspective by assessing the value associated with any new investment or stock dilution event. As with any investment, history is no guarantee of future performance, and any investment decision must balance the risk against the potential return.
If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing and how to find opportunities for angel investing on the platform.
Originally published at https://www.propelx.com on October 15, 2021.
