Dilution Does Not Need to Be That Scary

Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies. The information on this page should not be construed as legal advice.

It has been my observation that a lot of first-time founders and investors believe that dilution is an evil tool of oppression in every instance. They tend to be scrupulous about protecting their equity stake and insisting upon extreme anti-dilution protection.  It is prudent to fully understand corporate transactions and look out for your interests.  However, fully understanding these transactions means understanding that dilution is not some sort of monster.  To the contrary, dilution is a natural consequence of the growth of a venture scale company receiving capital from outside investors.

When a company raises money and provides investors with equity in the company, the transaction is based on a valuation of the company.  If the company is worth $3 million and an investor purchases $1 million of new securities, they will own 25% of a $4 million company.  The stock that the owners of the company held prior to the transaction now represents 75% of the equity stake it did prior to the transaction, but there was a proportional increase in the overall value of the company.  If the next transaction that the $4 million company engages in is an equity financing with a pre-money valuation of $8 million and they raise $4 million, the stockholders will be diluted once again.  This time, their percentage ownership will be 66.7% of what it was prior to the financing, but the overall value of their stock, albeit a smaller percentage of the company, has doubled.  This is all what I refer to as “fair” dilution.

Dilution becomes a bad thing, and begins to resemble the monster above, when stock of a company is diluted without a proportional increase to the company's value. In some instances, the proportional increase might be subjective, such as what value a new cofounder adds to the company. In other instances, such as finance transactions, the proportional increase is based on a dollar figure. For example, in a dilutive financing, money is raised at a lower pre-money valuation than the value at the close of the previous financing. Sometimes this happens because of natural devaluation of the company. However, sometimes this happens for oppressive reasons. In either case, investors may seek the protection of anti-dilution provisions, whereas founders may seek protection in maintaining influence on the Board, in the stockholder vote (and class vote), and through minority shareholder rights. Founders are also prudent to understand the mathematical consequences of transactions under various scenarios.

Related Pages:

Minority Shareholder Oppression: Freezeouts, Squeezeouts, and Dilution