Startup founders need a comprehensive understanding of equity dilution. This includes key aspects such as what it is, how it works, what causes it, and how it can be calculated.
Such an understanding will aid your fundraising efforts, show the effects of shareholder ownership, allow in-depth projections and analysis to be carried out, and much more.
There is a fair bit to take on board so let’s get started with what you need to know:
The Basic Premise of Equity Dilution
As early-stage startup founders will only be too well-aware, fundraising decisions must be made to facilitate growth. Having said this, it must also be understood that raising funds will impact their equity share and that of all shareholders.
Once founders have completed a round of fundraising their percentage of company ownership is decreased. This makes it critical to fully understand the long-term implications of equity dilution. It must also be clear how equity dilution scenarios can be calculated over different periods (for example, 5 years). Before getting into examples of a stock dilution formula, let’s take a look at convertible debt, stock options, equity dilution, and how equity is diluted:
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What Is Convertible Debt?
Convertible debt is the more common name for a convertible loan. It is an option right that a business gives to a lender in return for a low-interest loan. From the beginning of the agreement, both parties have the intent to repay part or all of the loan by converting it into an agreed number of the company’s common shares at a future point in time.
The loan agreement states repayment terms and includes the agreed timeframe, the price per share for the conversion, and the interest rate to be paid until that conversion occurs.
The agreement between the two parties will state the “conversion privileges” which outline when the lender can choose to act by converting the loan to shares. It can also include a “callable option” which allows the borrower (in this case the startup) to force conversion when its share value reaches a certain threshold for a defined period of time.
In this way, convertible debt agreements suit both parties. It helps the company raise needed funds and allows the lender to receive a fixed rate of interest until a conversion is triggered. From that trigger point, the lender will own shares in the company.
Startup founders who believe their shares will increase in value over time find that taking on convertible debt is an attractive way to raise necessary funds. This is because it allows them to reduce equity dilution (i.e. without giving up too much ownership of their company).
As an example:
If your business is looking to raise $1 Million and its shares today are worth $20, it would need to sell 50,000 shares in order to reach that target. By taking advantage of a convertible debt it can defer until the shares are worth $50 each and then would only need to issue 20,000 additional shares.
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What Are Stock Options?
Stock options are also a type of equity compensation. It is common for early-stage startups to grant them to employees and executives. Shares of stock are not directly granted by the company. Instead, derivative options on the stock are given.
What that means is those who hold stock have the right (but not the obligation) to buy an agreed number of company shares at a pre-agreed, fixed price. This is generally called the strike price, grant price, or exercise price.
There are conditions attached to stock options such as a cliff period which is the time an employee must work for the company before their stock options begin to vest. This is usually 1-year. From there, these options vest over a set period of time which is usually 4-years.
Other conditions that employees must be aware of include what happens to their shares if they leave the company, the expiry dates of the granted options, and any potential tax implications. The latter factor will depend upon the country the employee is registered in for tax purposes.
The attraction of stock options works well for both founders and employees. It allows early-stage founders who are on tight budgets to attract essential, experienced personnel at lower than would normally be expected salaries. This is because they are adding the incentive of stock option purchase to the remuneration package.
The structure of the stock option agreement also encourages employees to remain with the company over the longer term. Stability in key operational areas of the startup is seen as being a fundamental part of the company’s growth.
As for employees, once their stock options begin to vest and they take up the offer to purchase shares they then become part owners of the company. With that in mind, it stands to reason that these employees are eager to go the extra mile to ensure the company succeeds.
After all, as the company goes from strength to strength, the value of the company stock will rise. This means the employee will make a profit on the difference between what their agreed original stock option purchase price was and what it is valued at should they decide to sell.
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What Is Equity Dilution?
Equity dilution is also termed share dilution. As will be seen later in the piece, equity dilution can happen in a wide variety of ways but let’s first concentrate on two of the most common reasons:
The first is when a company issues new shares to investors during fundraising rounds. The impact of this new share issue is to dilute (reduce) the ownership percentage of existing shareholders’ ownership in the company.
The second is when those who hold stock options exercise their right to purchase stock which will cause the same type of impact as issuing new shares to investors.
With more shares given to more people, it stands that existing holders of the company’s common stock will then own a smaller (or diluted) percentage of the company.
The other knock-on effect comes from the fact that existing shareholders will see their share of the company’s profits also diluted. This occurs because the total number of company shares increases but the company’s earnings after tax remains the same, meaning earnings per common share go down. It is often the case that this also lowers the share price.
An Example of How Equity Can Be Diluted:
Here’s a very straightforward example of how equity can be diluted:
Let’s assume a startup has 10 shareholders with each shareholder owning 1 share, or 10% of the company each. If those investors each receive voting rights to make company decisions based on share ownership, each investor would have the mentioned 10% control.
The company then issues 10 new shares and one single investor purchases all 10 of the new shares. This would mean there are now 20 total shares in all but the new investor would now own 50% of the company.
As for the 10 original investors, they would now only own 5% each of the company rather than their original 10%. That is because their shares have been diluted to 1 in 20 rather than the previous 1 in 10. This is a clear case of share dilution.
It is evident that company leaders need to mitigate such downsides. This can be achieved by ensuring that money raised through the issuance of new shares is used to grow the company’s revenue and its after-tax profits. By doing so they are raising the PPS (Price Per Share) above the pre-issue price.
A Stock Dilution Formula:
Here’s how founders and investors can calculate dilution using a stock dilution formula. Many find that using a simple equation is the way to think about dilution. That formula is:
Value of Ownership after Dilution > 1 / (1 – N)
Where N = the amount of ownership you are giving up as a percentage
The main focus of this equation is that you want to maximize your ownership stake value. This means that if you dilute your ownership stake by N your company’s value would need to increase by 1/ (1-N) to ensure your equity worth is the same as it was before your stake was diluted.
An example of the above equation:
If you currently own 50% of a company valued at $2 Million your stake is worth $1 Million. If due to the issue of new shares your ownership is diluted by 20% but the value of your company stays the same this would mean that your shares are now only worth $800,000 – i.e. Your stake worth has been reduced by $200,000 (which is 20% less than what it was).
To keep your values in the company the same, you will need your new ownership. This is 40% multiplied by the company’s value (C) to = $1 Million. To figure that out using simple algebra – Take the value of C at $2.5 Million. This is because $2.5 Million is 1.25 times the original company value (which was $2 Million).
Extrapolating that out – 1 / 1-N should be 1.25 which is the multiple factors of the company’s value in order for you to keep your original stake value of $1 Million.
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Further Sources of Equity Dilution:
While we have discussed ways that fundraising, the exercising of stock options, and convertible debt can create equity dilution there are many other ways that are not always clear to founders. Here are 5 other reasons to be aware of:
- Issuing of new preferred stock – This is to raise money.
- Issuing new common stock – This is for co-founders as well as others.
- Issuing new stock options – This is Further Source of Equity Dilution: new hires.
- Issuing new warrants – This is for lenders.
- Increases in conversion rate of preferred to common shares. This would normally happen in a recapitalization situation.
Even larger areas that can cause share dilution include such things as liquidation preferences, participation rights. and cumulative dividends.
Equity dilution can have a drastic impact on the value of your startup’s portfolio. When any dilution occurs it is imperative that adjustments are accurately made for such things as earnings per share and projection ratios for valuation.
That journey will rely heavily on taking advantage of your equity situation and the impact that dilution can have on all concerned.