What is stock dilution in finance, and how to manage It effectively

It’s a major milestone when a small business grows to the point where you’re considering fundraising. However, it’s no secret that fundraising decisions are complicated. Whenever a company announces a round of funding, one thing that current (and future) employees want to know about is stock dilution—and you need to be prepared to answer their toughest questions.

In this article, we’ll unpack what dilution in finance is and everything else you need to know to make confident fundraising decisions.

What is dilution in finance?

Stock dilution describes an event in which a company issues new shares and thereby reduces the percentage of existing shareholders' ownership.

Dilution can be created by a wide range of activities, including but not limited to: a private market capital raise, an initial public offering (IPO), the acquisition of another company, employees exercising stock options, or convertible bonds, preferred shares, or warrants converting into stock.

These activities increase the total share count of a company, which in effect "dilutes" the value of all existing shares, assuming all else equal at the company.

For the purposes of a profit-sharing program, or liquidity upon an exit event, dilution reduces the amount of money shareholders receive for an equal number of shares.

These terms help to explain the concept of a stock dilution:

• Issued shares: Shares that have been sold to the shareholders
• Restricted stock: Shares that owners cannot sell due to a restriction
• Treasury stock: Stock repurchased by the issuer from shareholders‍
• Outstanding shares: Shares currently held by investors

What causes stock dilution?

There are several reasons why a business may explore issuing new shares. Some of the most common causes of stock dilution include:

• Increasing on-hand capital for growth. Offering new shares of your company to the open market can create a quick injection of cash to fund growth opportunities.
• Acquiring a new company. When your company acquires a business, it may choose to offer shares to stockholders of the organization you’ve acquired.
• Obtaining a business loan. Companies occasionally issue convertible securities to lenders to obtain business loans. When lenders convert those securities to stock, this event dilutes the existing pool of shares.
• Removing other stakeholders. In some cases, majority stakeholders may issue new shares to intentionally dilute an existing shareholder that the company either wants to remove or influence them to make a decision they would otherwise disagree with.

How does stock dilution work?

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.

Creating or offering new shares

Companies generally offer new shares to expand and add additional shareholders when raising money. Companies can also award common stock to employees, though this is usually done as stock 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, those shared are subject to the ebbs and flows of the stock market. This could result in an immediate increase in value or cause 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

Vesting refers to the amount of common stock owned by an employee. In some cases, startups offer equity as part of compensation packages for new employees. That equity comes with a vesting schedule, locking in the employee’s service for a specific period if they want access to the stocks.

Once the vesting period expires, the stock is awarded to the employee. It works the same as an option, causing dilution once it vests.

In some cases, like a promotion, or compensation increase, 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 differently. The average vesting period for startups is four years, with the first year generally described as a “cliff” year when 0% of the equity award is vested.

Mergers and acquisitions

When a company acquires another, it often involves combining the stock of each entity into one. This can dilute the value of existing shares, which can be a concern for current investors. Before acquiring another company, evaluating the potential dilution effect on current shareholders is important. That’s done by the purchasing firm receiving the company-owned common stock for the acquired company. That stock is often sold at a discount, which dilutes shares for the common shareholders.

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How is stock dilution legal?

Stock dilution is considered a standard and often necessary financial practice that occurs when a company issues additional shares of stock, thereby reducing the ownership percentage of existing shareholders.

Here are the requirements and regulations companies must abide by in order for stock dilution to be conducted legally:

1. Disclosure requirements: Companies are required by law to disclose their plans for issuing new shares, typically in their financial statements, SEC filings (like the 10-K or 10-Q reports), or during shareholder meetings. Shareholders are usually informed about potential dilution before it happens.
2. Corporate governance: The decision to issue new shares is usually made by the company's board of directors, often after a vote by the shareholders. This process ensures that the decision aligns with the company’s best interests and has the backing of those who have invested in it.
3. Market regulation: The issuance of new shares and the resulting dilution is regulated by securities laws and market rules. These regulations ensure that companies do not issue shares arbitrarily and that shareholders are protected from unfair practices.
4. Capital formation: Stock dilution allows companies to raise capital without taking on debt, which can be crucial for growth and innovation. It’s a legal way for companies to secure the funds needed for expansion, research, or other strategic initiatives.

Stock dilution is a regulated process that is transparently disclosed to shareholders, and governed by corporate laws and market regulations designed to protect investors and facilitate business growth.

Share dilution: Pros and cons

Share dilution seems bad at first glance, but it could be good in some scenarios. It is typically a targeted strategy with a specific end goal.

Pros:

New funding opportunities for business growth

Companies can boost revenue by utilizing that new cash to scale its sales process. 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 suitable and should be promoted as such before issuing the new common stock.

Potential for higher dividend payments

Executives raise funds when they identify opportunities for business growth. When those opportunities become realities, earnings likely increase—and as a result, so do the dividends that shareholders receive.

Long-term growth in share prices

If the programs you’ve funded through stock dilution prove to increase profits over an extended period, the price of your company’s stock may increase as well.

Cons:

Reduced ownership stakes

The most obvious impact of dilution in finance is reduced ownership for all of your current shareholders. While the price of each share may grow over time, the number of shares owned by each shareholder decreases when the company issues new shares.

Decreases in dividend payments

Although shareholders may receive increased dividends if earnings increase, they will also receive lower dividend payments in the event that your company’s earnings don’t increase after a dilution event.

Lower share prices

Similar to the impact on dividends, dilution in finance isn’t a silver bullet solution for generating additional earnings. If your company’s plans don’t generate the expected results after a dilution event, the stock price will also decrease.

Remember: This article is not meant to serve in the place of financial advice; always consult a professional.

Tips for startups to manage stock dilution

Research different financing options

If the fundraising process is new to you, find an advisor who can help you explore alternative options.

For example, debt is an option that most startups shy away from because significant revenue may be several months or years out. Alternatively, crowdfunding is a good option where equity offerings can be limited. And there are always small business financing options like loans, lines of credit, and grants, depending on the needs of your business.

Model what dilution will look like for different options

Another great way to limit negative impacts is to simply do the math. Some business owners look at the potential cash flow increase from an equity offering. Still, they fail to consider how this will affect the company's equity multiplier and impact existing shareholders. Those who buy stock in your company are among your most significant resources. Give them the consideration they deserve by mitigating their potential loss from dilution.

A fully diluted cap table is one of the tools you’ll need for this step, which will show you the total number of outstanding shares, including the totals for each option if 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 an excellent practice to get into to control costs and streamline your company. The lean startup method involves only offering your minimum viable product (MVP). The result is minimizing costs and testing hypotheses using cost-effective marketing techniques and simple metrics. Done correctly, it can eliminate the need for more fundraising.

Ramp offers an alternative to stock dilution

Ramp offers a non-dilutive funding option called commerce sales-based underwriting, perfect for startups and growing businesses with online shopping carts. By connecting to popular platforms like Shopify, Stripe, Square, Amazon, and WooCommerce, Ramp uses your sales data to secure up to 30x higher credit limits on average.

This approach, combined with Ramp’s expense tracking software, gives you greater spending power through non-dilutive debt, while helping you better manage costs and control expenses—all without giving up any equity in your company.‍