On Dilution

5 min readNov 16, 2016

When dilution comes up as a topic in a startup, most people’s faces turn sour. Before trying to answer why that is, let’s answer *what* it is. According to Investopedia, dilution refers to “a reduction in the ownership percentage of a share of stock caused by the issuance of new shares.”

On its face, getting less ownership seems like it could be a bad thing. But, of course, things aren’t so straightforward. This post is designed to illustrate why.

To make our discussion as clear as possible, we’ll have a running example with XYZ startup throughout.

Startup: XYZ
Valuation: $10M
Number of Outstanding Shares: 10M
Price Per Share[1]: $1

Let’s say you’ve done well on your interview and you’ve been given 200K shares that vest over four years.

Employee: You
% Ownership: 2%
Number of Shares: 200K
Price Per Share: $1
Total Equity Value: $200K

What I would like to convince you of is that if all you know is that you’ve been diluted you don’t know whether it’s a good thing or a bad thing. Let’s see why by looking at three scenarios XYZ might find itself in: a down round, a sideways round, and an up round.

Down Round

A down round is when a company’s valuation decreases compared to the previous round.

Startup: XYZ
Previous Round Valuation: $10M
Current Pre-Money Valuation: $8M
Amount Raised: $4M
Current Post-Money Valuation: $12M
Current Number of Shares Outstanding: 15M

Pre-Money Valuation: the valuation of XYZ prior to investment

Post-Money Valuation: the valuation of XYZ after investment

So what does this mean for you? It means you have less money, on paper.

Employee: You
% Ownership: 1.33%
Number of Shares: 200K
Price Per Share: $0.8
Total Equity Value: $160K

Some would consider 33% dilution significant. However, in the end, the true culprit for your total equity drop is the price per share dropping. Period. Beyond that, the situation is likely to be worse than what’s depicted above as A-round investors are likely to have protections that give them more shares in the event of a down round. Ultimate effect: you’re diluted even more.

Sideways Round

A sideways round is one where the value of the company doesn’t really move. It’s unchanged or negligibly changed. They’re better than down rounds, but not by very much.[2]

Startup: XYZ
Previous Round Valuation: $10M
Current Pre-Money Valuation: $10M
Amount Raised: $4M
Current Post-Money Valuation: $14M
Current Number of Shares Outstanding: $14M

So what does this mean for you? Very little.

Employee: You
% Ownership: 1.44%
Number of Shares: 200K
Price Per Share: $1
Total Equity Value: $200K

Yup. You’ve been diluted by about 28% and you still have $200K in total equity. You simply own 28% less of the company.

Up Round

An up round is one where the value of the company appreciates from the previous round.

Startup: XYZ
Previous Round Valuation: $10M
Current Pre-Money Valuation: $20M
Amount Raised: $4M
Current Post-Money Valuation: $24M
Current Number of Shares Outstanding: 12M

So what does that mean for you? You’re a little bit richer my friend :-).

Employee: You
% Ownership: 1.67%
Number of Shares: 200K
Price Per Share: $2
Total Equity Value: $400K

Here, you’ve been diluted by about 16%. Your total equity value is bigger because the company has been appraised at a higher value. When the investors agreed to the updated price per share, that’s where your money was made. Your dilution was irrelevant. If XYZ raised $8M instead of $4M the dilution would be about 32%. And what would the net effect be to you (aside from a smaller ownership percentage)? Nil. Your total number of shares would still be 200K and their total value would still be $400K.

Why Do People Think Dilution is Universally Bad?

Having looked at our three examples above, we can begin to guess why people think dilution is universally bad: people are using the “all other things being equal” logic. That’s effectively what the above examples are doing. They change only one of the factors that create dilution: pre-money valuation. Under the “all other things being equal“ logic, when dilution decreases your equity value increases. But let’s be super clear: dilution is an effect of the amount raised and the previous and current valuation as dictated by the price per share of a company. Talking about dilution without knowing these things makes little sense as a non-founder/CXO.

For a startup employee that isn’t a founder/CXO, the one case in which dilution is relevant, is when you’re considering joining an early stage company and you’re trying to do the back-of-the-napkin math on what your future winnings might be. If for example, a company is offering you 10% and you expect the startup to raise a couple more rounds, you may conclude those rounds will involve dilution, and you may end up with ~2% of the company. If you think the company can be a $500M company, you might be inclined to believe that you’d end up with $10M (~2%) versus the naive $50M (10%).

Hopefully it’s little more obvious why knowing only the percent of dilution isn’t enough information to know whether or not it’s a bad thing.

Notes

[1] When a company’s valuation is considered, the preferred price per share is used. Common share price is determined by a 409A valuation. This valuation corresponds to the employee strike price in an Incentive Stock Option (ISO) plan. This price is generally much lower than the preferred price per share. As a liquidation event approaches, the price of Common’s shares approaches that of the Preferred. Preferred is usually comprised of investors. Common is usually comprised of angels, founders, and startup employees.

[2] When people join a startup, they’re definitely not hoping that the company’s value will go sideways. They’re hoping they’ve grabbed onto a rocket ship. The missed time with loved ones, the late nights in the office, the skipped holidays aren’t to help a company’s value go sideways.