How Does Dilution Work?
Founders and non-investor shareholders worry a lot about dilution. I hear it all the time from first-time entrepreneurs in particular, who are very concerned about reducing their ownership stake in the business at all.
But bear with me and you’ll see that dilution isn’t bad at all as long as you have a good business. In fact, it’s quite normal.
What is Dilution?
In the corporate context, dilution happens when a Company issued additional shares, but the shareholder who is being diluted keeps the same number of shares. This typically happens upon investment, which is the purchase of shares directly from a company, rather than a purchase from its existing shareholders.
Let’s use an example where two co-founders start a brand new company with no assets, and the two founders have equal ownership in their business, ACME Corp.
The Company then sells 100 shares to an investor, which changes the ownership interests of all shareholders.
Now each shareholder has a 1/3 interest instead of a 1/2 interest. This might look terrible for the founders, because they have smaller slices of the same pie, and have lost a bit of control over corporate matters. But in practice, this usually increases the total value that the shareholders have, even accounting for the reduction in percentage ownership.
Most Dilution Is Neutral
For all of you reading this who arrived afraid of losing everything to investors, let me start by saying that neutral dilution is the rule, not the exception. The key is simply to ensure that investors really add value commensurate with the shares they receive, whether the value is purely in the form of money, or also in the form of guidance and industry connections.
Let’s look at the example from above again, but assume that ACME had a valuation of $100 when Ben and Alan were the only shareholders. We’ll add another fact; that the Investor invested $50. Therefore, after the $50 was added to the company, its value is $150: $100 of value from Ben and Alan’s work, and $50 of value in the form of cash.
Notice that the Investor’s ownership tracks the money that it invests. With its money added, it has contributed 33% to the overall value of ACME, so it appropriately owns 33% of the shares. Ideally, shareholders will not see the total worth of their ownership change after investment—only the percentage ownership changes.
Things start to get more interesting depending on how that $50 is used. If Ben and Alan use it to hire great talent and their product does really well, then the company’s valuation will increase beyond $150, which would mean a net increase in worth for all shareholders even without a change in ownership percentage! The slices are still smaller than they were before the investment, but the pie is so much bigger that you’re actually better off.
On the other hand, if Ben and Alan waste it the money, the valuation might drop below $150.
But I’m getting ahead of myself. Stay tuned and I’ll blog about valuation soon. Understanding valuation and dilution together makes investments a lot less scary.