May 5, 2022
Venture Capital

Dilution: What is it and How can it Affect Your Investments?

Nicole Areias

hat infamous three syllable word. Founders, VCs, and LPs are always talking about it, but nobody wants it. 

Of course we’re talking about dilution. A phenomena that can generate a good deal of friction during financing rounds.

While not necessarily a good or bad thing, dilution is regarded as the standard in early-stage equity financing. Understanding dilution and the financial instruments behind it can give you a better sense of how your investments might pan out and how you can protect them.

What is dilution?

If you’re the sole founder of a startup, chances are you start off owning 100% of the company right? In other words, every single share. But as fresh capital comes in, and employees looking to be compensated with stock options are added to the team, new shares are issued and their holders are awarded a small percentage of the company. 

Then, when additional shares are issued to new investors at the next funding round, those already holding shares end up owning a smaller, or diluted, percentage of the company. The higher the total number of shares held by all investors in a company climbs, the less percent ownership existing shareholders have. 

Since startups finance their growth by conducting several rounds of fundraising – Pre-seed, Seed, Series A, B, C and later growth rounds—the earlier you get in, the more diluted your equity will be. 

Meanwhile, those that are last in likely won’t experience any dilution. That being said, a $1,000,000 investment made at the pre-seed stage will look very different from one made in a series C round.

In reality, dilution is more complicated than this table lets on. Let’s take a look at others ways dilution occurs.

Convertible Securities and Debt  

Convertible instruments, such as simple agreements for future equity (SAFE) and convertible notes, grant future preferred stock to investors in earlier funding stages. These investments act as cash now-equity later deals that help young companies access the capital they need to accelerate their business. 

A SAFE is a type of convertible security that converts to equity at a company’s next priced round, usually the Series A, regardless of the dollar amount raised. In exchange for the added risk they take on at this stage with their early investment, SAFE holders often get their future shares at a discount and with favorable terms. 

Convertible notes on the other hand, are a form of debt. Unlike SAFEs, these investments accrue interest and do not have a specific maturity date. They instead convert when (and if) the company reaches an agreed upon milestone that triggers equity conversion. 

Different dilutive effects

Both kinds of investments can cause dilution with their valuation caps and conversion discounts. Valuation caps, which are often negotiated to determine the price of the shares that will be issued to note holders when their money converts into equity, can work against existing shareholders. 

A company valuation at a subsequent funding round that exceeds the valuation cap will drive down the price-per-share for note holders relative to the price new investors will pay, giving them a bigger bang for their buck (i.e. more shares for their investment).

Conversion discount also offer a haircut on share prices, but because they lower prices by a fixed amount they tend to be less dilutive. Typically these allow SAFE holders to pay 15% to 20% less than Series A investors. 

Pre vs. Post-Money SAFEs

With SAFEs, it also matters whether they are pre-money or post-money agreements. Pre-money agreements postpone dilution until the next round, at which point everyone–the founders, the note holders, and the new investors—gets diluted equally. 

With post-money SAFEs, investors negotiate the percentage of the company they’ll own before the next round of investors are cut in, giving everyone a clearer sense of what their percent ownership will come out to. 

Its important to keep in mind that while safes typically affect investors from one round to the next, convertible notes can convert much later down the line and their valuation caps, discounts and interest rates can have dilutive effects on any shareholder that buys in before conversion.

In either case, there can be a lot of guesswork when it comes to these methods of early stage fundraising. For this reason, investors should always keep an eye out for outstanding notes. 

Raising Priced Rounds 

Each time a price round is raised, existing shareholders lose out on some of their ownership. In addition to past investments coming into play, the creation of new shares for the investors looking to buy in is another source of dilution. 

Whether you’re an existing shareholder, or making you first investment in the company, your percent ownership will depend on whether the company valuation that is negotiated is a pre-money or post-money valuation

In other words, is the deal based on the company’s value without yet including this round of funding, or does the valuation reflect the investment that’s going to be made?

Let’s say a fresh group of series B investors and the founding team agree that  Investible Inc. is worth $3 million. If they agree that this what the company will be worth after a $600K investment, this is a post-money valuation, and the investors now have a 20% stake in the company. If the company was valued at $3 million pre-money, i.e., before adding the $600K, then the investors will have instead own a 17% stake in a company that is now worth $3.6 million. 

Priced rounds are also where employee stock option plans that have the potential to flood a company with new shares are established.   

Stock Options

The authorized option pool refers to the common stock that is reserved for granting equity to early employees, consultants, advisors and directors in the form of stock options.A new pool is often established during a series A round, and made large enough to cover the estimated number of option grants between the first and the second financing. Pushing for a larger can prevent the need to add more shares between financing rounds and dilute investors sooner than expected. It can then be topped up in subsequent funding rounds, or decrease in size in response to investors' ownership demands.   

Because the option pool involves creating and adding new shares, as opposed to reallocating existing ones, they also chip away at your investments. In rounds where shares are being added to the pool, consider whether they are being added before issuing stock to new investors–this will only dilute previous shareholders. Dilution can also happen later down the line when those granted equity exercise their options and buy in at the pre-determined strike price. Once options are exercised, the shareholders authorized shares are now outstanding, thereby diluting prior holdings. 

It Isn’t Always About Ownership 

Ownership is certainly important, especially when owning a certain number of shares of stock affords you voting rights. 

However, depending on how well the company is doing, your original investment can also decrease in value. The value of your investment can of course increase and decrease with or without the issuance of new shares, i.e. independently of your percent ownership. 

A down round—a round at a company valuation that is less than the valuation of the prior round—or bridge round, can dilute both ownership and value. During these rounds, a company will issue new shares at a lower price-per-share, and so are worth less than its outstanding shares. 

Let’s say Investible Inc. was worth $5 million in Series A. But after hitting some roadblocks along the way, is subsequently valued at $3.8 million in Series B, your $800K investment in Series A, which at the time bought you 800,000 shares at $1 is now worth $640K at $0.80 a share. Additionally, while you once owned 16% of the company, the issuance of 400,000 new shares will also drop your ownership to 14.8%. 

Is dilution really that bad?

It’s important to keep in mind that dilution can be a good sign. Companies will need several rounds of fresh capital to fund their growth and become more profitable. The more money that comes in, the higher its valuation will climb, and so too will the value of your stake. 

Yet, if you have a real winner on your hands, a percent or two can make a huge difference. Investors want to maintain as much of their equity ownership as they can, to profit as much as possible when it's time to exit.  

They can do this in a number of ways. 

Protecting Against Dilution 

The best way to maintain a sizeable stake is to continue to participate in later financing rounds. Investors can ensure they get the opportunity to do so by negotiating pre-emptive rights, or a “Right of First Offer”, at the time of their first investment.  

This way, when the company issues new shares, the investor has the right to participate in the round and maintain their current share or increase their stake. While these are great for the investor, they are not so founder friendly as they can deter new investors from coming in.

To curb the number of stakeholders that have them, companies will only award these rights to major investors. They will usually also set provisions, or “carve-outs”, that limit these rights. Carve-outs exclude investors from exercising these rights with some issuances of stock (or other securities). 

These may include stock options, warrants to lenders or equipment lessors, stock splits, stock dividends, and the conversion of preferred stock to common stock. In these cases, the issuance of stock will dilute your ownership.

Protecting against value dilution differs 

To protect against value dilution investors should own convertible preferred stock that has anti-dilution provisions built in. These provisions act by reducing the Conversion Price, which in turn increases the Conversion Ratio according to which preferred stock is converted into common stock. 

When the price drops each share of preferred Stock will get you a greater number of shares of common stock.

The most common kind of anti-dilution protection is Weighted-Average Anti-Dilution. While it doesn’t provide full protection from price dilution, these provisions ensure a conversion price somewhere in between the lower share price in a down round, and the prior conversion price. 

Final Thoughts 

While dilution does chip away are your potential earnings, the goal is to see your investment go up in value even as the percentage of the company that you own goes down. 

For those especially successful investments, you can also negotiate conditions that will protect both the size and value of your stake in a company–at least to some extent. 

Truth be told, talk of valuations and how equity gets carved up is a whole lot more complicated when brokering a deal. Always be sure to look over the numbers and capitalization tables, and to even model long-term dilution across various scenarios: the good, the bad and the average.  

Understanding dilution and how it might play out can help give you a better sense of what your investment might one day be worth.

Interested in learning more?
Join to receive Venture Capital research, guides, models, career tips, and many other great insights delivered straight to your inbox.

Interested in the full research paper?

Click here to sign up below for free access to the full research library report.
Download the Full Research Report!