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How does dilution work?
Cap tables and pie.
Dilution is a lot like pie. To put it in the words of a financially minded baker:
“So let’s say my business is a pie. When I raise money and take on new investors, I need to create more slices. That means the size of my slice gets smaller as a result. However, the investors set a new, higher price to buy into the business. So although my slice got smaller, the overall pie is now worth more. Therefore, I’m actually a wealthier baker, with my smaller slice, than I was before.”
Like we said, more shares are getting created in the underlying business. While the absolute number of shares you own stays the same, the denominator of total shares gets bigger. As a result, this drives your “fully diluted” ownership down. “Fully Diluted” simply means all the possible shares out there in the wild.
But if the company, or pie, is becoming more valuable each round, you don’t really mind dilution because the total dollar value of your slice increased. In fact, you’re better off than you were before. Here’s an example:
When Does Dilution Occur?
Dilution strikes whenever new (more) shares are issued (created). Here are some common scenarios:
When Employees Exercise Options: When an employee exercises their option to buy shares in a company this increases the total number of shares outstanding. Before the employee just had the “option” to buy shares. Now that they’ve actually cut a check to own them, more shares are created and the pie gets bigger.
When Convertible Warrants or Bonds are Exercised: These are usually issued to angel investors as a convertible note or founder friendly banks (like a Silicon Valley Bank) before a valuation is set in stone. When debt is converted to equity, this makes the number of outstanding shares go up, which dilutes the existing holders.
When the Firm Completes a Fund Raise: This is the most well known scenario. When a company does a fund raise they can raise primary dollars, secondary dollars, or a combination of both. Secondary dollars are just existing shareholders selling to new shareholders. For example, a longtime founder might sell some of their shares and take some dough off the table. None of this money goes to the company to fund operations, only to the employee to buy something nice. When a firm raises primary dollars they create new shares out of thin air. Doing so increases the denominator that existing shareholders measure their holdings against. We’ll talk about pro rata rights, which prevent dilution of current shareholders, in a future post. At the end of the day, you hope the fund raise was done in good times, and a new, higher valuation was set for the company in the process. More on that below.
IPO: An IPO is similar to a private fund raise in the sense that it can have both primary and secondary components. The primary offering creates new shares and dilutes existing shareholders on the cap table in the same way. You also hope that the valuation of the IPO raise is higher than the more recent round.
Once again, remember that it’s not necessarily a bad thing if any of these events occur in conjunction with an increased valuation. Ask yourself:
“Would I rather have 10% of a company worth $2 million, or 8% of a company worth $20 million?”
So How Much Dilution is Normal?
Early money is the most expensive money you’ll take. It’s when the most dilution typically occurs. But keep in mind, this is also where the company’s value goes from theoretically nothing to something. So there’s that.
Series A is usually where institutional investors (brand name firms) come aboard and provide money and credibility to a growing firm. Dilution of 20% to 25% is typical, which is higher than most subsequent rounds.
From Series B onward, companies have a better handle on dilution because the valuation has grown and the amount they are raising is a smaller percent of the new valuation. They also have more mature operations and some revenue to help defray the mounting hiring costs. So now they can usually keep dilution to ~10% per round.
Can Dilution be Bad?
Yes. Dilution is really bad if you have a “down round”. This is when the firm raises money at a valuation lower than the last round. This is a double kick in the shorts for existing share holders because not only is their percent ownership in the business going down, but the underlying company is also worth less. Yikes!
Do All Companies Get Equally Diluted?
No. If you are a premium asset you can raise more money while giving less of the company away. Think about it - if you need to raise $100M to fund operations for the next 18 months, a company that raises at a $1 billion valuation dilutes their shareholders twice as much as a company that raises at a $2 billion valuation.
Dilution is a tax to play the game, one you should be willing to play if your company’s valuation is going up by, say, 50% each round.