A Closer Look at Stock Dilution

A Thought Leadership article we liked from Propel(x):

Stock Dilution in Startup Investing — Good or Bad?

So, you have taken the plunge and invested in a startup and received your stock.

But what happens in the future when new investors come in? It is important for you to understand stock dilution.

What is Stock Dilution?

Stock dilution happens when a company issues additional stock.

Imagine you know an amazing pastry chef who is famous for her pecan pie but does not have enough money to bake her next batch. The chef proposes a deal with you — if you promise to pay for 30% of the ingredients, she agrees to bake a pie that she will cut into ten slices and agrees that you can eat three of those slices. Simple, right? You pay for 30% of what it takes to make the pie and in return, you get to eat 30% of the end product.

But soon after your agreement with the chef, a storm hits Mexico that wipes out half the national pecan crop, driving up the cost of pecans. The chef realizes she now needs more money to buy the ingredients, so makes an additional deal with five new customers, promising them one slice each once the baking is done. So, this means the finished pie will now be cut into 15 slices. You will still get to eat three slices, but instead of this being 30% of the whole pie (3/10), it is now only 20% of the pie (3/15).

Stock dilution in a company works a bit the same way as the pecan pie example. Let us say you invest in the seed round of a startup that has issued 10m shares at a valuation of $0.10 per share, which means the company is valued at $1m. You invest $100k and purchase 1m shares, which means you own 10% of the company. Time moves on, the company grows and needs more funds to expand, so decides to go to market again and do a Series A round of capital raising. To enable this, the company issues another 5m shares, increasing the total number of shares to 15m. Once these new shares are sold, you still own your original 1m shares but your percentage ownership of the company has now reduced to 6.7%.

Dilution is a fact of life when investing in startups. It comes with growth. When successful companies grow, it is common for them to raise capital in multiple funding rounds. Each funding round involves issuing more shares, which consequently results in dilution. But as noted above, a lower percentage ownership of a more valuable company could potentially be worth more.

Understanding Stock Dilution

It is important to realize that stock dilution is not necessarily a bad thing — any new investment should aim to increase the value of the whole, so that even if your percentage ownership goes down, the pie should get bigger so that your share of the pie could actually be worth more. Note this is not always the case, so it is vital to understand the implications of total value (more on that later).

To help understand the principles of stock dilution, let us look at some visuals. The pie charts shown below represent the share of a company based on the example described above, i.e. a company raises a Series Seed round with 10m shares, with two founders having 4m shares each, a stock options pool of 1m shares and a single early investor who puts in $100k for 1m shares. Then, a further 5m shares are issued in a Series A round, which are all taken by a single investor. The total number of outstanding shares now goes up to 15M shares. The pie charts show that the original investor in the Series Seed round who purchased 10% of the company has had their ownership reduced to a smaller slice of the pie in the Series A round, with their stake going down to 6.7% (i.e., 1M shares out of a total of 15M shares).

You can find more information on dilution in the article on Medium entitled Fundraising 101: What’s the Real Value of a Startup? along with some additional information on valuing startups.

You can also find out more information about stock dilution in this article on Capitalization Tables.

Company Share Structure

When evaluating an opportunity to invest in a startup, it is important to understand their shareholding structure. When a startup is formed, the total number of shares the company can create is defined in the articles of incorporation, known as...

Read the rest of this article at medium.com...

Thanks for this article excerpt and its graphics to Propel(x).

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