Founders and financial leaders need to understand dilution because it directly affects the value of the stock that they and their shareholders own. Before issuing any new stock, it’s important to measure the impact the issuance will have on existing shares. Cutting additional slices from the same pie will bring everyone’s ownership stake down just a bit.
Common investors should also read up on this topic. Dilution affects individual shareholders, not just corporate board members and executives. When a company issues new stock or grants stock options to employees, that dilutes the value of existing shares. In this article, we’ll explain exactly what dilution is and what steps you can take to manage it.
What is dilution in finance?
When a company issues new shares of stock after its initial public offering (IPO), the existing shares decrease in value. Think of it as cutting slices of a pie into smaller pieces. The pie itself doesn’t decease in size, but each individual piece is worth a bit less. Those pieces, aka shares, will either increase or decrease in value based on the revenue and costs of the company.
Companies sometimes issue new shares to secure a partnership, award an employee, or raise money. In most cases, the new shares issued will be common stock, which awards voting rights to the shareholder. In cases where the company is looking to raise equity financing without giving up voting rights, they may issue preferred stock, which is essentially a bond that pays dividends.
Companies usually only issue new stock after carefully evaluating the potential dilution effect on their current shareholders. It’s also important to look at the message that the issuance of new shares sends to public investors. There will be an immediate drop in share value which could be a catalyst for some investors to sell.
What causes stock dilution?
Dilution is not synonymous with market loss, though its effect looks similar. When the market causes a stock to drop in price, it’s usually due to decreased revenues, poor sales, or other factors that affect the industry. Stock dilution is caused by an intentional action by the company that affects the 409A valuation of common shares. Some other examples of what may cause stock dilution are:
Stock options converted to common shares
Stock options don’t give the holder equity in the company. That doesn’t happen until the option is exercised. At that point, it’s converted to common shares, increasing the total number of shares the company has issued, which is what ends up causing dilution. Common shareholders will see it reflected in falling share prices, a slight dip for smaller options and a larger one for large blocks of stock.
For stock options to work, they must first be granted by the company. The board of directors needs to agree that the common stock needed for conversion will be issued. That means that the company knows dilution is coming and can prepare for it. Common shareholders aren’t privy to that same knowledge and generally find out after the fact.
Creating or offering new shares
Companies generally offer new shares when they are looking to raise money or wish to expand and add additional shareholders. They can also award common stock to employees, though this is usually done as options, not actual shares. Company accountants record those options as compensation, using the fair market value of the option.
When new shares are issued publicly, they are subject to the ebbs and flows of the stock market. This could result in an immediate increase in value or work against the company, causing share prices to go down. For best results, most firms will precede the issuance of new stock with an internal promotional campaign or press release explaining their motivation.
Vesting of employer awarded common stock
It’s a standard practice for startups to include equity as part of the compensation package for new employees. That equity comes with a vesting schedule, locking in the employee’s service for a specific period. Once the vesting period expires, the stock is awarded to the employee. It essentially works the same as an option, thereby causing dilution.
In some cases, additional equity may be granted before the vesting period is over. This doesn’t necessarily start the clock over, but the equity agreement may be modified in other ways. The average vesting period for startups is four years, with the first year generally described as a “falling off the cliff” year when 0% of the equity award is vested.
Of course, many startups don’t go public right away, so the equity awards don’t have any real-world value until the initial public offering or private sale of the company. Prior to that, the potential value of the stock is based on the company valuation. It can still be diluted when new stock is issued, but that’s just projections on paper, not actual cash value.
Mergers and acquisitions
Merging two companies together, or one company acquiring another, involves combining the stock of each entity into one. That’s done by the purchasing firm acquiring the company owned common stock for the acquired company. That stock is often sold at a discount, which dilutes shares for common shareholders.
Ideally, the company will do a share buyback offer prior to making any kind of acquisition deal. This makes the sales process easier because there will be fewer shareholders involved. In other cases, when the acquiring firm has targeted a prospect company, they may go to the open market to buy a majority of shares. This generally does not cause dilution.
Is share dilution good or bad?
Share dilution seems bad at first glance, but there are scenarios where it could be a good thing. Dilution should never be viewed by shareholders as a punitive action. It is typically a targeted strategy with a specific end goal. When a company issues new shares of stock, it usually indicates growth. When employees exercise stock options, the stock price is usually up. Let’s consider scenarios where dilution can indicate positive changes and scenarios where it can be cause for concern.
Let’s say your company has been generating modest revenue, share prices have been holding steady or growing at a reasonable rate, and you have a sales model in place that’s scalable. The only obstacle is cash on hand, so you issue some new common stock and sell it on the open market. Cashflow problem solved.
By utilizing that new cash to scale your sales process, the company can boost revenue. Share prices will dip in the short run because of dilution, but the increased profitability will eventually raise them to a new level. That’s a win for common shareholders. In this scenario, dilution is a good thing and should be promoted as such prior to issuing the new common stock.
A “con” situation would be issuing new common stock when the company is struggling, and you don’t have a plan to dig yourself out of it. The new shares will generate cash for the company, but existing shareholders will take huge losses if the downtrend continues. Dilution will be swift, and recovery will be incredibly difficult.
These are just two examples where issuing new common stock will cause dilution, one with good results and the other with a bad outcome. Both can be predicted and controlled by the company if you properly plan ahead. The same line of thinking applies to the handling of stock options. We’ll cover more on that in the section below.
3 tips for startups to manage stock dilution
Startups face several obstacles that established firms have already overcome. Cashflow is one of the major ones. Raising capital through equity offerings that cause dilution seems like an easy way to get past those, but it can affect long-term shareholder returns if done improperly. To avoid this, consider the following steps.
Research different financing options
Equity is precious. It’s not something to be given away or discarded lightly. That’s the mindset you’ll want to cultivate from the beginning if you’re an entrepreneur launching a startup or a finance team exploring equity options. If the process is new to you, find an advisor who knows how to structure a company and limit the issuance of common stock.
There are other ways to finance a company. Debt is an option that most startups shy away from because significant revenue may be several months or years away. Crowdfunding is a good option where equity offerings can be limited. Asking for a line of credit from your local bank or credit union could also work, depending on the development needs of your firm.
Model what dilution will look like for different options
Do the math. Some business owners look at the potential cash flow increase from an equity offering, but they fail to calculate the impact on existing shareholders. Those who buy stock in your company are among your greatest resources. Give them the consideration they deserve by mitigating their potential loss from dilution.
One of the tools you’ll need for this step is a fully diluted cap table. This will show you the total number of outstanding shares, including the totals for each option if they are exercised. Incorporate these numbers into your dilution model so you fully understand the impact of issuing new common stock or offering stock options to new employees or partners.
Review lean startup techniques to minimize costs
This does not affect dilution, but it is a good practice to get into to control costs and streamline your company. The lean startup method involves putting out only your minimum viable product (MVP), minimizing costs, and testing hypotheses using cost effective marketing techniques and simple metrics. Done properly, it can eliminate the need for more fundraising.
The term dilution is defined in our Ramp Finance Glossary.