Stock 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 stock 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 stock 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.
With Carta, calculating stock dilution after each funding round is easy. Our cap table software keeps everything up to date automatically. Learn more about Carta cap table management.
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.