Dilution: Protecting Your Share of the Pie

1-sentence takeaway: Dilution happens when a company issues more shares, reducing your ownership percentage—like adding water to your juice, making it less concentrated, but potentially increasing the overall value.

It’s common to feel anxious about dilution. After all, seeing your ownership percentage shrink can feel like losing ground. However, dilution isn’t always bad. It’s crucial to understand why dilution happens and how it can impact your equity’s value.

What is Dilution?

Imagine a pie representing a company’s total equity. You own a slice—say, 10%. When the company issues new shares (bakes a bigger pie), your slice remains the same size, but it now represents a smaller percentage of the larger pie—maybe 8%. This decrease in your percentage ownership is dilution.

Why Does Dilution Happen?

Companies issue new shares for various reasons, often positive ones:

• Raising capital: This is the most common reason. New shares are sold to investors to fund growth, hire talent, or develop new products. Think of it like inviting new bakers to contribute ingredients and help make a much bigger, tastier pie—everyone benefits, even though the original bakers own a smaller percentage.
• Employee stock options: Offering equity compensates employees and aligns their incentives with the company’s success. This is like sharing slices of the pie with the bakers who make it delicious.
• Mergers and acquisitions: When companies merge or one acquires another, new shares may be issued as part of the deal.

Good Dilution vs. Bad Dilution:

• Good dilution: Happens when the company raises capital at a higher valuation than the previous round. Though your percentage ownership decreases, the overall pie grows substantially, increasing the value of your slice. For example, owning 10% of a $10 million company is less valuable than owning 8% of a $20 million company.
• Bad dilution: Occurs when the company raises capital at a lower valuation (a “down round”). Your ownership percentage shrinks, and the overall pie’s value doesn’t increase proportionately, or even decreases—resulting in a smaller, less valuable slice.

Protecting Yourself from Bad Dilution:

While you can’t prevent all dilution, understanding the potential causes can help you make informed decisions:

• Ask questions: If your company is raising capital, inquire about the valuation and the terms of the deal.
• Negotiate: When joining a company, negotiate your equity package carefully, considering the potential for future dilution.
• Stay informed: Keep track of your company’s performance and fundraising activities to understand the potential impact on your equity.

Anti-Dilution Provisions:

Some companies include anti-dilution provisions in their shareholder agreements to protect investors from down rounds. These provisions adjust the conversion ratio of preferred stock to maintain investors’ ownership percentage if the company raises money at a lower valuation. Learn more about anti-dilution protection.

So here’s what we covered:

• What dilution is and why it happens.
• The difference between good and bad dilution.
• How to protect yourself from the negative impacts of dilution.
• Anti-dilution provisions in shareholder agreements.