Dilution
Description
Dilution occurs when a company issues new shares of stock, typically through fundraising rounds such as Series A, B, or C. When new shares are issued, the ownership percentage of existing shareholders decreases because the total number of outstanding shares increases. This means that the percentage of the company owned by each shareholder decreases, which can have a negative impact on the value of their shares.
Dilution can be calculated using a simple formula:
New shares issued / (Existing shares + New shares issued) = Dilution
For example, if a company has 1 million shares outstanding and issues 100,000 new shares in a funding round, the dilution would be 9.1%:
100,000 / (1,000,000 + 100,000) = 0.091, or 9.1%
Dilution can also occur when stock options or convertible debt are converted into shares. In these cases, the conversion of the options or debt into shares increases the number of outstanding shares, which reduces the ownership percentage of existing shareholders.
Frequently Asked Questions
Dilution can have a negative impact on the value of a shareholder's stock because it reduces the ownership percentage of existing shareholders. This means that the earnings or dividends per share are spread out over a larger number of shares, which can decrease the value of each individual share.
Not necessarily. Dilution can be a necessary part of a company's growth strategy, especially if the new funding allows the company to expand operations or invest in new products or services. Additionally, dilution can sometimes result in an increase in the overall value of the company, which can offset the negative impact on individual shareholders.
Companies can minimize dilution by being strategic about when and how they issue new shares. For example, they can try to raise as much funding as possible in each round to minimize the number of rounds needed, or they can use other forms of financing such as debt to avoid issuing new shares.
A startup raises a Series A round of funding, which involves issuing new shares to investors. As a result, the ownership percentage of existing shareholders decreases.
A publicly-traded company issues new shares of stock to finance an acquisition, which dilutes the ownership percentage of existing shareholders.
A company issues stock options to employees, which can dilute the ownership percentage of existing shareholders if the options are eventually converted into shares.
Further Reading Materials
"The Founder's Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup" by Noam Wasserman
"Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist" by Brad Feld and Jason Mendelson
"The Basics of Understanding Dilution in Startup Equity" by Marisa Sanchez
