Understanding Stock Dilution

An article we liked from Thought Leader Bryce Warnes:

What is Stock Dilution?

When a company authorizes new stock, the value of existing stock is reduced.

This is called stock dilution (or share dilution).

Covered in this article:
Why stock dilution occurs (with an example)
Common causes of stock dilution
Stock dilution due to SAFEs (with example)
Anti-dilution provisions in term sheets

Why does stock dilution occur?

The easiest way to understand why stock dilution occurs is with a simplified example.

A super simple example of share dilution

Say you’re the sole founder of your company. You’ve authorized 100 shares, and purchased them. Now, you own 100% of the company.

You want to incentivize employees to join your company by offering them equity. So, you authorize 25 additional shares, and issue them to your new employees.

Now, there are 125 outstanding shares in your corporation—100 belonging to you, 25 belonging to employees.

Prior to your issuance to new employees, you owned four quarters of your company: 4/4 = 100%

But now you own four fifths: 4/5 = 80%

You now own 80% of your company, instead of 100%. And 20% of your company now belongs to employees. At the most basic level, this is stock dilution in action: You’ve “watered down” your ownership stake by introducing new stock.

Share dilution in real life

The likelihood of stock dilution playing out in the real world the way it plays out in our example is extremely small.

For starters, most founders authorize 10 million shares when they incorporate—or one million, at the very least. And those shares are each typically priced at a fraction of a cent each. And so on.

We’ll get to some more concrete real life examples of dilution shortly. But first: What events are likely to cause stock dilution at your startup?

What causes stock dilution?

In a startup, stock dilution typically occurs for one of three reasons:

Your company authorizes more shares as part of a priced round. These shares are issued in exchange for investors’ money, in order to raise money. (The new shares fall under the category of secondary offerings.)
Your company expands its stock option pool. During a priced round, your term sheet will specify how many additional shares you are required to authorize as compensation for future employees.
SAFEs or convertible notes convert as part of a priced round. A priced round triggers SAFEs and convertible notes to convert, meaning you’ll have to...