Equity is a motivator for most early-stage founders, employees, investors, and other shareholders. Poor management of the cap table and dilution in the early days can be costly in the long run.
Founders need to pick and choose when issuing additional shares and diluting themselves and existing shareholders. As always, we recommend consulting with a lawyer or legal team regarding your cap table and dilution.
Learn more about share dilution and what it means for your business below:
What is share dilution?
As put by the team at Investopedia, “Share dilution is when a company issues additional stock, reducing the ownership proportion of a current shareholder.
Shares can be diluted through conversion by holders of optionable securities, secondary offerings to raise additional capital, or offering new shares in exchange for acquisitions or services.”
Primary types of share dilution
The type of conversion or sale will impact the share dilution. This is typically boiled down to 2 major types of share dilution — primary and secondary share dilution. Learn more about each type of dilution below:
Primary share dilution
Primary share dilution happens when a company raises additional capital. Taking on new capital means that any existing shareholders will be diluted — as more financing capital comes in, the ownership % of existing owners will decrease.
Secondary share dilution
On the flip side is secondary share dilution. This happens when existing owners sell their shares to a new investor. The price at which the shares are sold impacts what the level of dilution will be.
Reasons for share dilution
Dilution when a company issues additional shares. This can happen in a number of different ways. Check out a few examples below:
For financing options and capital needs
The most common reason for share dilution is when raising capital, typically from venture capital funds. VC and Private Equity funds invest capital for equity. In turn this is issuing additional shares and diluting the existing shareholders on the captable.
Related Resource: Private Equity vs Venture Capital: Critical Differences
Employee stock options and equity compensation plans
As put by the team at Investopedia, “The term employee stock option (ESO) refers to a type of equity compensation granted by companies to their employees and executives.” Whil an employee stock option plan offers individuals options in the business there are also equity compensation plans which offer equity directly in the business. Both of these instances will dilute your existing shareholders as additional shares are being issued.
Related Resource: Employee Stock Options Guide for Startups
To introduce new shareholders into the holdings
There is also the introduction of new shareholders. This can be someone like an advisor or mentor that has gone above and beyond for your business. In the early days of a business, some founders will offer advisors equity instead of cash.
Related Resource: Advisory Shares Explained: Empowering Entrepreneurs and Investors
Impact of share dilution
Many founders, early employees, investors, etc. are motivated by equity and the opportunity to grow the value of their shares. With this said, many founders need to pick and choose their spots when issuing additional shares to keep dilution in mind. Poor management of the cap table in the early days can be costly in the run.
Erosion of ownership percentage and control
As new shares are issued the ownership of existing owners will slowly erode. For many founders this can result in control and less impact on the overall direction of the business.
Effect on earnings per share (EPS) and dividends
For later stage companies, dilution can impact earning per shares and dividends. As more shares are issued, the earning per share goes down.
Potential impact on stock price
Related to the point above, as earnings per share go down with dilution this can potentially be less of a draw to investors and cause the stock price to lower.
Strategies for avoiding share dilution
As we mentioned above, founders need to pick and choose when issuing additional shares in their business. Avoiding dilution and maintaining ownership of the business can have huge impacts in the event of an exit or sale.
As always, we recommend consulting with a legal team or counsel when determining different strategies regarding your cap table and dilution.
Look at other financing alternatives
Equity financing is the not the only financing option when it comes to raising capital for a startup. Over the last few years there has been an explosion in funding alternatives for startup founders. Ranging from debt to entirely new funding models. A few examples:
- Pipe
- Corl
- Clearbanc
- Calm Company Fund
Related Resource: Checking Out Venture Capital Funding Alternatives
Focus on generating internal cash flow for growth
The best way to avoid dilution is by relying solely on your business to fuel growth and expansion (of course, this is easier said than done). When limiting the need for external capital, you’ll be able to maintain ownership of the business and would (potentially) only need to issue new shares when hiring new employees and executives.
Create clear terms from the start
Having clear terms from the start when fundraising will help model and project your dilution. By having a gameplan in place and a realistic view of dilution will help manage your cap table and issue new shares as needed as you raise capital and hire new talent.
Limit excess funding with SAFEs
Introduced by YC, SAFEs have taken over the startup funding world. As put by the team at Forbes, “A Simple Agreement for Future Equity (SAFE) is a contractual agreement between a startup company and its investors. It exchanges the investor’s investment for the right to preferred shares in the startup company when the company raises a future round of funding. The SAFE sets out conditions and parameters for when and how the capital will convert into equity. Unlike a convertible note, a SAFE does not accrue interest or have a maturity date.”
However, both pre and post money SAFEs can have a different impact on the founder. We recommend consulting a lawyer or legal team when determining how to leverage different financial instruments for your business.
Related resource: The Startup's Handbook to SAFE: Simplifying Future Equity Agreements
Build strategic partnerships and alliances
Strategic partnerships and alliances can be a valuable way to scale your business and avoid dilution. By having different partners and alliances you can grow your business and resist the need to raise additional equity financing and maintain ownership of your business.
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