Unlike public companies where value is set by the market, private companies use independent appraisers to assess their value. Fair market value is the current value of a private company’s common stock and it determines the strike price.
Stock dilution, also called equity dilution or share dilution, happens when a company issues additional shares, which reduces the ownership percentage of existing shareholders in a company. Generally, founders, employees, and investors of private companies are all subject to stock dilution.
Common causes of stock dilution
- The need for new capital: When private companies need more capital, they typically issue new shares to investors in a funding round, which reduces the overall percentage of ownership for existing shareholders.
- Increasing employee pool: Incoming investors usually require companies to create a stock option pool. The timing of when the stock option pool gets created determines which shareholders are diluted. Generally, if the pool is expanded before a fundraising round, only previous option holders are diluted. If the pool is expanded after a fundraising round, then all shareholders, including investors, are diluted.
How dilution works
Imagine there are two co-founders of a startup and 1,000 shares issued between both. This means each founder owns 500 shares, or 50%.
However, their company needs more capital in order to expand. A VC firm invests in the company and gets 200 shares in return. After those new shares are issued, there are now a total of 1,200 shares in the company. Each founder still owns 500 from when the startup was founded, but now their ownership stake is 42% (500/1200) instead of 50%.
Even though dilution causes you to own less of the company percentage-wise, it doesn’t necessarily mean your stock is worth less. In fact, the price of stock (FMV) generally increases after a funding round, so the overall value of your shares may actually go up. You just own a smaller piece of a bigger pie.
Is accepting a new investment worth the stock dilution?
You can calculate stock dilution using this basic formula (which Paul Graham writes about here):
In general, if the company’s value increases to more than 1 / (1-N), it is worth it to accept the investment.
For example, let’s say a top tier VC firm is offering capital in exchange for 10% of the company.
1 / (1 – 0.1) = 1.11
This means that if you believe that your company can improve its valuation by 11%, it would be worth the dilution.
DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta, Inc. (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.
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