Moisan Legal P.C. Blog

Friday, February 28, 2014

Dilution - The Basics

Most successful founders and early owners of startups will experience dilution.  Dilution is a reduction in a owner's ownership percentage caused by the issuance of new stock.  Dilution can also occur when holders of stock options (e.g., employee equity holders) or holders of other optionable securities exercise their options. When the number of shares outstanding increases each existing stockholder will own a smaller (i.e. diluted) percentage of the company.   Dilution is often misunderstood in part due to the simple fact that it is an emotional moment in a founder’s existence – it is important to remember, a lesser percentage of something is better than 100% of nothing.

Share dilution is also imminent if your startup needs to raise additional outside capital (e.g., seed/angel and venture capital).  This often occurs in high growth industries where several injections of capital money may occur.  As a result, it is very rare for the founders to continuously own 100% of their business.  The concept of dilution makes sense: as additional people own new shares of a company those people already holding shares will experience dilution of their own shares. 

However, understanding how you’re likely to get diluted over time tends to be more difficult.  Unfortunately most founders don’t give much thought to their ownership percentage and the dilution of their shares over long periods of time.  Experienced startup lawyers can guide founders and early employees to ensure their investments and hard work are protected over time.  Here’s a simple example of dilution:

1. Founders establish the company and own 100% of the stock.

2. Founders issue 10% of the company to the early employees they hire.  Now the founders own 90% and the employees own 10%.

3. After an angel round is done the early investors acquire 10% of the company for their initial investment.  Now the founders own 81%, the employees own 9%, and the investors own 10%.

4. After a venture round is done the venture capitalists negotiate for 30% of the company for their investment.  Now the founders own 56.7%, the employees own 6.3%, the investors own 7%, and the venture capitalists own 30%.

Over time dilution adds up and can significantly reduce the value of the founders’ equity.  Dilution can also be impacted by other terms of investment such as “option pools” and “top ups” of employee stock options to continue attracting talented employees.

The earlier you are in the company the more you will be diluted.  But dilution is not a bad thing.  It’s a normal and regular occurrence in startups.  The problem is that people who misunderstand dilution tend to be overly optimistic about their likely take in a startup.  As long as you understand dilution and make smart decisions as you accept seed money and venture capital there should be no problem.  The attorneys at Moisan Legal, P.C. are ready to counsel you through the implications of dilution so you can focus on achieving your company’s goals.

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