By: Steve Masur and Cassidy Lopez
If you’ve ever made orange juice from concentrate, you probably already have a good feel for how equity dilution works. When you put the orange juice concentrate in a pitcher, you have a small amount of, well, really strong concentrated juice. As you add water, the water dilutes the original concentrate, which then represents only a small portion of your beverage. The same holds true for equity.
What is Equity Dilution?
Equity dilution refers to the reduction in the percentage ownership interest—shares of stock or membership units—of current stockholders of a corporation or members of a limited liability company when the company issues new shares or units, whether that be through a private placement of securities or an initial or follow-on public offering (IPO/FPO). The number of shares or units held by existing shareholders or members remains the same, though when the company increases the total number of shares or units issued and outstanding, each preexisting stakeholder will subsequently own a smaller ownership percentage of the enlarged pie. This sounds scary to stockholders and LLC members, but keep in mind that a company’s value increases whenever money is infused. In other words, existing stockholders or LLC members will own a smaller portion of the company, but the reality—or the hope anyway—is that what they do own is worth more.
Calculating Equity Dilution
To calculate equity dilution, you as a stockholder or LLC member need to know three things: (1) how many shares/units you own, (2) how many shares/units were outstanding prior to the investment, and (3) how many new shares/units were issued in the financing.
- Determine Your Original Ownership Percentage: Divide the number of shares/units you currently own by the total number of the company’s issued and outstanding shares/units prior to the investment. For example, if you own 20,000 shares of a corporation and the corporation has issued 100,000 total shares of stock, you own 20% of the company.
- Find the Number of Shares/Units Outstanding After the Financing: Add the newly issued shares/units to the total number of shares/units issued and outstanding by the company prior to the investment. In this example, if the corporation issues an additional 25,000 shares to a new investor, add 25,000 to the 100,000 then-outstanding shares to find the company now has 125,000 total shares of stock outstanding.
- Calculate Your New Ownership Percentage: Divide the number of shares/units you currently own by the total number of shares/units issued and outstanding by the company after the investment. Continuing with this example, if you own 20,000 shares of the corporation, and now the corporation has 125,000 shares outstanding, divide 20,000 by 125,000 to find you now own only 16% of the company.
- Determine Your Equity Dilution: Subtract your new equity percentage from your old equity percentage to find the amount by which you have been diluted by the investment. In this example, subtract 16% from 20% to find you own 4% less of the company than you did before.
Staying on this example, let’s now assign a valuation to the company. Prior to the investment, the corporation had a pre-money valuation of $1,500,000. The corporation issued 25,000 shares to a new investor in exchange for $500,000, making the company now worth $2,000,000. Prior to the financing, you owned 20% of the company, which at its prior valuation, meant your ownership interest was worth $300,000, or $15 per share. After the financing, your ownership interest was diluted to 16%, but the company’s new post-money valuation makes your ownership interest worth $320,000, or $16 per share. You own a smaller percentage of the company, but that percentage is now worth more.
Check out this tool from OwnYourVenture as a great resource to visualize equity dilution.
Practically speaking, the only way to actually prevent dilution is to be the sole owner of your corporation or LLC. Though for founders who intend to take any outside investment, the key is to only grant equity in exchange for something (or someone) that will generate more value than what is given up. In other words, that 4% equity dilution should throw off a greater than a 4% increase in value to the company. Mechanisms to prevent dilution do exist, more often in later stage equity financings, though how they are structured and their implications to the various stakeholders vary and will be discussed in a later LawTalk blog post.