How Does Dilution Work?
By: Pete Singh
At the outset, dilution is the process of pro rata deduction of ownership percentage as additional holders are added to a company’s capitalization chart. Dilution happens as the number of shares held by a person is static while the total number of outstanding shares (the denominator) grows (e.g. 1/1 = 100% | 1/10 = 10% | 1/100 = 1%). If you bring investors or others onto your company’s cap chart dilution is unavoidable.An important distinction and point of confusion is the difference between authorized shares versus issued and outstanding shares. The number of authorized shares is the maximum number of shares that a company can issue before changing its charter to create more. The number of issued and outstanding shares makes up the denominator for calculating ownership percentages on an ongoing basis. Companies will often have as many as five million or ten million authorized shares, but may only issue a fraction of those to founders, employees and investors. What matters is that the total number of issued (not authorized) shares represent ownership on a fully-diluted as-converted basis.The following capitalization charts represent ownership before and after an investment to purchase 5% of the company.In this example, you can see the Founder’s, Employee’s, Contractor’s, and Pool’s ownership percentages drop by 5% in aggregate while the new Investor gets 5%. The number of shares owned by each person stays the same, but the denominator is bigger, so each ownership percentage is smaller. Also, notice that there are two million authorized shares (but that is irrelevant for these calculations). Although a particular holder’s ownership percentage shrinks as investors and others are added to the capitalization chart, the value of the shares held by a particular owner increases - ideally in an amount that more than offsets the dilution.
Remember, each holder keeps the same number of shares, since they are issued by the Company and not sold or given away by existing owners. Thus, the total number of issued and outstanding shares (the denominator) larger, and each holder’s ownership percentage is conversely smaller.
Keep dilution in mind when allocating equity at the outset and as you grow. When you offer equity to others, communicate that they will receive a certain number of shares or units in your company. That number might equal a certain percentage today, but they won't necessarily own that same percentage forever.
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