What is dilution?

Dilution is the reduction in the ownership percentage in a certain company as an effect of the issuance of shares.

There is a number of calculations to make before getting your final percentage of dilution. Let’s work them out with an example.

Let’s say you are the only owner of a company and you own 1000 shares. What happens if you issue 100 more shares?

The new total number of shares is 1000+100 = 1100 shares. You own 91% (1000 / 1100) and the buyer of the newly issued shares owns 9%.

But what is the formula behind the dilution calculation?

Continuing the example from above, you now own 91% of the company. What’s the dilution? It is 9%.

To calculate this, you first need to calculate the dilution coefficient.

The number of shares you give away in the example is 9%. So this is what the calculation would look like

In the previous case, there is only one owner of the company. But what happens if there were two initial owners of the company and new shares are issued?

Let’s take the case when only one of the owners buys the shares. As above, we have 1000 shares in total. Each owner has 50% of the shares, which is 500 shares respectively.

100 more shares are issued, which brings the total amount of shares to 1100. Post issuance, one of the owners has 600 shares and the other has 500 shares, so 54,54% and 45,45% respectively.

In this case the formula for the dilution coefficient is slightly adjusted and it goes this way

Following the formula, the calculation looks like this:

This is the dilution calculation for the person who buys the additional shares, assuming that he buys them all.

If we talk about the shareholder that doesn’t buy any of the new shares, his situation doesn’t change.

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Why would you be subject to dilution?

There are three occasions when you issue shares:

1|  Raising capital

When you are raising capital, you give away equity. This is the typical case and it is identical to the example above.

2| Stock options or warrants

These two cases are usually quite similar. Stock options and warrants are the type securities that do not trigger the issuance of shares right away – at the time the contract is signed. These two securities only imply that a person will be able to enter your capital structure in the future.

3| Convertible debt

In this case, debt holders will convert to shareholders at a trigger event, usually a funding round or an exit. Hence, this causes dilution for the initial shareholders.

There are other situations when a company issues shares and is subject to dilution, but these are the main three.

The last two types of securities signal to investors that dilution will happen at a future event. However, they are interested in finding out what exactly the dilution is prior to committing to invest. This is why some contracts ask for the shares on a fully diluted basis.

What’s a “fully diluted basis”?

Let’s say that you own 50% of the shares of a company and the other 50% belongs to another shareholder. There is also a person who is holding a stock option.

Stock options usually refer to a specific number of shares, which means that at the time that the option is exercised, a certain amount of shares will be issued.

“On fully diluted basis” means that you need to calculate how much you are going to own at the time the options is exercised. You can do that by subtracting the dilution you are going to get at the issuance of shares from the amount of shares you own today.

What usually happens when you are raising capital from a VC firm is that you are issuing shares for them, but you will also issue some additional equity. That ranges between 5-10%. You will allocate these shares in a separate entity – for instance, foundation or an escrow. These shares will be reserved for securities such as employee stock options or convertible debt.

The reason why you do that is that makes it easier to discuss equity stakes on a fully diluted basis. This amount of shares might never be used entirely. But on the plus side, even though they are shares with voting rights, they are controlled by the company. So they don’t impact the voting process.

Calculating the dilution for stock options is relatively easy, because you know the exact amount of shares that are going to be issued. However, calculating dilution for convertible debt is a bit more difficult. In this case the number of shares at conversion will be determined by the valuation at the trigger event.

To make the dilution calculations you take the worst case scenario – you assume that the debt holders will convert at the cap. Since the cap is the maximum, so you can already calculate the maximum number of shares that will be issued.

What about you? What is your experience with dilution? Did you have any difficulties or were you prepared to talk about it during investment negotiations? Let us know in the comments!

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