Dilution occurs to an investor's ownership percentage in a company when the company issues more shares, typically during a capital raise. Here's a step-by-step explanation of how it happens:
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Initial Ownership: Imagine you own 100 shares in a company, and there are 1,000 shares in total. Your ownership percentage is 10% (100/1,000).
Company Decides to Raise Capital: To grow the business, the company decides it needs more capital. One common way to do this is by issuing new shares to sell to investors.
Issuance of New Shares: Let's say the company issues 500 new shares. This increases the total number of shares from 1,000 to 1,500.
Dilution of Existing Shares: Before the new shares were issued, you owned 10% of the company. After the issuance, you still own 100 shares, but now those 100 shares represent a smaller fraction of the company: 100/1,500 = 6.67%. Your ownership percentage has decreased due to the dilution effect, even though the number of shares you own hasn't changed.
Impact on Value: Theoretically, if the company raises capital efficiently, using it to grow the business and increase its value, the value of your shares could still go up in the long run. However, your voting power and the proportion of future earnings you're entitled to have been reduced. (Unless you write in some clever stipulations through a SAFE agreement that converts your ownership percentage so the share of the pie you get stays the same until the SAFE is terminated).
Preventive Measures: To protect themselves from dilution, some investors negotiate anti-dilution rights. These rights can give them the option to purchase additional shares at a discounted rate in future funding rounds to maintain their ownership percentage.
Dilution is Not Always Bad: While dilution reduces an investor's percentage of ownership, it is not always a negative outcome. If the capital raised is used effectively, the company's market value can increase. This can lead to the investor's smaller percentage being worth more in absolute terms than their larger percentage was before the capital raise.
Dilution is a fundamental aspect of investing in growth companies, particularly startups, where several rounds of financing are often necessary to reach commercial viability or scale operations. Investors weigh the potential for dilution against the opportunity for significant returns if the company succeeds.
Article found in Startups.
