Savvy founders should understand the concept of share dilution — no matter where they are in their business journey. Dilution can directly affect a founder's financial stake in their company.
Growing your business can take many forms: raising funds from investors, hiring new employees, or even acquiring another company.
But each of these growth opportunities has something in common: the potential to dilute the existing shares of your company. Before engaging in an activity that could dilute shares, it’s important to understand what it means for the business and how it happens.
What is share dilution?
Share dilution, also called equity or stock dilution, refers to a decrease in the ownership percentage of existing shareholders when additional shares of a company's stock are issued. It typically occurs as part of an equity financing round or when a company awards stock options or grants to employees.
This can happen to shares owned by a founder, employee, or investor. In some cases, dilution can result in a founder or owner losing their majority stake in the company. That’s why understanding when dilution happens — and how to track it — is so important.
The above is a dashboard from the Fidelity Private Shares℠ Next Round Planner. This shows the dilutive effect of a round of Series A financing for a founder. Although the founder's equity percentage decreased from 90%, they now own 54% of a much more valuable asset.
When does share dilution occur?
There are some common instances when share dilution occurs. This results in the value of the existing shares decreasing because they make up a smaller portion of the overall shares.
When raising funding
A founder might offer investors equity in the business in exchange for their investment. If new shares are created to do so, then the result is share dilution. In addition to receiving a stake in the company, investors sometimes earn voting rights and a say in the future of the business.
When increasing shares or options offered to employees
In most cases, early-stage companies will create an option pool containing roughly 15% of shares. Any shares issued from this existing pool aren’t dilutive because they’ve already been carved out to give to employees.
However, if you’re taking investment and an outside investor requires you to increase your option pool as part of that financing event, the shares are allocated prior to the completion of the round. This type of dilution tends to mostly affect the company founder(s).
4 ways to manage share dilution for your company
Managing share dilution is important to help owners and founders keep their majority ownership. It can also keep shareholders and investors happy as the business grows.
Here are four ways to keep tabs on share dilution as you grow:
Maintain a clean cap table.
An accurate capitalization table, or cap table, is key to understanding how many shares exist and who owns them. With your cap table as the single source, you can make informed decisions around funding and manage any future share dilution. There are cap table management tools designed to help founders create and manage their cap table through every stage of business growth, from day one of issuing shares through an IPO.
Consider a variety of financing options.
Traditional equity financing is only one way to raise money from investors. Other examples of non-dilutive funding include small business loans, grants, asset-based lending, recurring revenue loans, and selling receivables. Venture debt may be an option for later-stage companies, but it may come with warrants that are dilutive.
Think about the future.
If you’re looking to build a business that will stand the test of time, it’s important to consider the future when evaluating share dilution. Calculate how much funding you need and try to keep it realistic and grounded in a solid business plan. That way you aren’t issuing more shares than necessary when taking investment in exchange for shares.
Similarly, it’s better to map out the potential dilution before executing it. You should be aware of exactly how the dilution will change any stakeholder dynamics and ownership before it becomes a reality. You can do this by using scenario modeling tools to help you see the various options and outcomes.
Understand anti-dilution provisions.
Some investors might negotiate anti-dilution provisions when participating in a priced round. These provisions protect the investor in the event of a down round, but they leave the door open for founders’ equity to be diluted. Carefully review an investor’s terms to understand how anti-dilution provisions might affect your equity.
How Fidelity Private Shares helps you manage your equity
Managing your share dilution is easier and less stressful when you use trusted software. Fidelity Private Shares offers a variety of tools for doing just that. The all-in-one platform can help founders automate their equity management workflows from the earliest stages of starting their business in one centralized location.
Whether it's dynamically keeping an up-to-date cap table, managing your 409A valuations, streamlining due diligence with an automated data room, or managing board members and stockholders, Fidelity Private Shares has a solution. Explore the platform today.
409A valuations are conducted by a third party.
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