Equity Dilution Management: Impact of Funding Rounds on Ownership
When raising money, one of the most important things to
consider is how that may dilute your investment. Equity dilution happens when a
corporation offers investors additional shares or when stock option holders buy
shares. A diluted ownership stake results from the distribution of additional
shares of common stock to existing shareholders.
There are several potential causes of equity dilution or a fall in the ownership proportion of current shareholders. It
is useful for various purposes, including financing acquisitions, recruitment
and retention, and raising capital.
Business leaders should thoroughly understand the common
causes of stock dilution and its consequences for the company's owners and
shareholders. This article provides a deeper dive into stock dilution,
explaining the concept, why it matters, and how to navigate its impacts.
Understanding Equity Dilution- An Example
Suppose you are the only founder and owner of the firm you
established. However, seeking equity financing to fuel your growth may reduce
your stake in the company. At the company's inception, you own everything.
Assume that, as your success grows, you have attracted the
investment of four additional shareholders. In return, you offer them a stake
in your business pro-rata basis. Your business now has five shareholders, each
with a 20% stake. Therefore, your original 100% ownership comes down to 20%.
Let's say your company attracts five new investors as it
grows. As a result, shareholding diluted to 10% for each stakeholder.
When a corporation issues new shares to the public, the
value and ownership of current shareholders decrease in direct proportion.
Private corporations are more likely to engage in equity dilution.
To raise substantial capital, many private companies sell
20-35% of their shares to outside investors. After this issue, the current
shareholders and founders will see a considerable reduction in their shareholding.
What is Equity Dilution?
Equity dilution occurs when a corporation issues more shares
of stock than it currently has outstanding, reducing the percentage of
ownership held by the firm's current shareholders. It also happens whenever
existing shareholders or workers get new shares from the firm in return for startup funding or labor. When a firm issues additional shares to the public, the
current shareholders' percentage of ownership in the business decreases.
The issuance of new shares of stock by a firm may dilute
existing shareholders' ownership stakes, mainly if the shares serve purposes
other than financing the business. Also, when a firm pays dividends to its
shareholders or offers convertible debt to investors or workers, the dividends
and debt dilute the shareholders' ownership stake in the company.
How Does Equity Dilution Operate?
Equity dilution, or share dilution, may occur in several
settings. These include:
- If shareholders of optionable securities decide to
exercise their stock options and convert their stakes into common shares, this
will raise the company's ownership percentage. People on the board, staff, and
others fall under this category.
- Secondary offers may provide companies with additional
funds for expansion or debt repayment.
- A firm may issue fresh shares of stock for purchase or
sale to finance acquisitions or exit strategies. In addition, smaller
businesses may provide services in return for a certain number of shares.
Impact of Equity Dilution
Equity dilution may have negative and positive effects
depending on the total number of shares in circulation. The impact of share
dilution focuses on the "Number of shares issued." Distributing
shares may benefit and harm a company's startup, its founders, and its
investors. So, to break it down:
Impact on Startups
The issuance of shares favors a startup since it motivates
the attainment of the company's objectives and the generation of more income.
However, this reduces profits per share for the company. Investors may decide
to liquidate their holdings in a firm if it has a history of issuing new shares
regularly. The result is a drop in share price.
Impact on Founders
Many businesses provide stock options to workers as a
substitute for cash bonuses. The present shareholders, including the company's
founders, will have their ownership interest reduced if and when they exercise
their options. Therefore, founder dilution occurs.
Impact on Investors
Equity dilution affects investors since it lowers the value
of each investor's shares. However, more significant investors may try to force
out smaller investors by diluting their shares.
It is neither entirely negative nor entirely positive. If it
favors one side, it hurts the other. Investors should also look for signs that
a firm is trading in an uncontrolled market or is issuing a large number of
shares entering the market to dilute the value of the shares and harm
Case Study: Positive and Negative Equity Dilution
While dilution of existing shareholders' holdings may look
negative, it often indicates a strategic purchase that may ultimately benefit
the stock price. Still, looking for signs of stock dilution is advantageous to
prevent any unpleasant shocks. Here’s an example of understanding if the
dilution is favorable or unfavorable.
Take the case of a new firm successfully closing its first
investment round. The company's pre-money worth was $15 million, and they
raised $5 million in return for 25% ownership. Every founding member and
current shareholder owns 18.75% of the business.
The money will go into improving the product and marketing
to new consumers. After two years in business, the firm is profitable and ready
to expand with new funding rounds. With a post-money value of $50 million, the
company's management plans to raise an additional $10 million in return for 20%
Since the funds can significantly boost the company's value,
the resulting equity dilution is positive. The value of the current
shareholders' shares has grown due to the company's expansion, but their
ownership proportion has declined. In addition, the original management and
investors still own a majority of voting rights, and the firm has grown due to
the inclusion of fresh perspectives and capital.
When a publicly listed corporation raises capital via
successive rounds of financing, diluting the equity of its existing owners, the
share price often falls.
For example, consider a retail establishment losing ground
to online retailers regarding sales and earnings. The company's management has
decided to issue fresh shares of stock at a steep discount to the market to
obtain extra funds.
When the firm raises $50 million in return for 25% of the
stock, the current shareholders' ownership proportion drops dramatically. The
company's share price has worsened as its financial performance has declined.
The corporation issues new shares of stock at a discount to
generate more capital, significantly diluting the stakes of current investors.
Consequently, the value of the existing shareholders' investment in the firm
continues to drop.
In this situation, the equity dilution could be better since
it served neither to finance expansion nor to generate value over time for the
company's owners. As a short-term fix to the company's financial problems, the
management team chose to employ equity financing; nonetheless, this decision
significantly reduced shareholder value.
Managing Equity Dilution
A few techniques may assist a business in raising funds
without issuing more shares, minimizing the effects of equity dilution.
Let's have a look at them in the following section.
- The foremost option is getting a loan. In contrast to
selling shares, taking out a loan does not dilute existing shareholders'
ownership. Remember that its important to pay back the loans, and some have
high interest rates.
- Investors and employees may also be issued convertible
debts or stock options. However, before giving convertible debt or stock
options, it is crucial to grasp the limitations and conditions associated with
- Certain companies might consider buying back their stock
shares as a countermeasure to diluting current shareholders' ownership
position. The corporation repurchases what it holds on the free market to lower
the total amount of shares in circulation and boost shareholder ownership.
- A company may also sell assets or issue bonds to raise
cash without issuing more shares. This strategy might help raise capital
without diluting existing shareholders' stakes.
Eqvista ensures your journey is marked by clarity, control, and sustained value:
Inevitably, a corporation will experience dilution at some
point. It's how most businesses get the money they need to invest and expand.
Every investor has to be aware of it, whether it's via secondary markets or
automated teller machines.
Because of its potentially devastating effects on portfolios,
investors must be alert for warning signs and familiar with how it will modify
their assets and share prices. You can use the round modeling tools for better
efficiency on this subject. Tools offer a great user interface with analysis
and results for informed decisions.