Equity Dilution: What is it, How it Works, and Why it Matters

Equity dilution might sound like a concept you’d only hear about in a boardroom full of suited-up executives. But it’s a concept every startup founder and business owner should understand.

Whether you’re negotiating with investors, planning your next funding round, or strategizing about your company’s future, understanding equity dilution can help you avoid surprises.

Equity dilution is all about how issuing new shares impacts ownership percentages. For founders, this could mean losing a slice of your pie. It could also affect your control over important company decisions, like appointing board members, influencing key votes, participating in future fundraising rounds, and making crucial choices about the company’s future, such as when and how to exit through an acquisition or IPO.

Below, we’ll walk you through everything you need to know about equity dilution to protect your ownership and company control.

What is equity dilution?

Equity dilution is the decrease in ownership percentage that occurs when a company issues new shares. When new shares are issued, the total number of outstanding shares increases, but the number of shares held by existing shareholders remains the same, effectively reducing their ownership stake in the company. Equity dilution can happen during fundraising rounds, mergers, acquisitions, or when stock options are exercised by employees.

When does equity dilution happen?

For startup founders, this typically happens during funding rounds when you bring on new investors. Each of these investors wants a piece of the equity pie in exchange for their capital, but if there’s not more equity to go around, you’ll have to add some—and that’s where the dilution happens.

“The goal for entrepreneurs is to find a balance between retaining sole ownership and access to resources,” says Aram Attar, Founder of The VC Factory. “Equity dilution is seen as a necessary evil. The trade-off is clear: the founders’ share of the pie is smaller, but they may increase the total size of the pie thanks to the additional capital injected.”

Equity dilution also happens when you grant stock options (or convertible securities) to employees. When your employees purchase these options, have shares vest, or convert bonds into stock, your equity gets more diluted.

How does equity dilution work?

It’s not just about your equity diluting—it’s about how that impacts your startup and existing shareholders. Once you know how it all works, you’ll be better able to make decisions and back them up.

For example, your other shareholders won’t be happy whenever you dilute their ownership. However, they’ll be more agreeable if you can justify how this is a long-term win-win.

Here’s a simple step-by-step breakdown of how equity dilution typically works:

• Initial share distribution: When a startup is founded, shares are distributed among the founders and early investors. This sets the stage for future dilution as the company grows and requires more capital.

• Issuing new shares: As your startup grows, it may need additional funding to expand. This is often achieved through funding rounds (Series A, Series B, etc.), where you issue shares to new investors.

• Dilution of ownership: When these new shares are issued, the percentage of the company owned by current shareholders decreases. Although their total number of shares remains the same, their proportionate ownership in the company reduces.

• Change in control and value: This dilution can affect control over company decisions and the value of each share (depending on how the new shares are priced compared to the old shares).

“Control and wealth can be mutually exclusive in a startup,” says Carolyn Deng, a Wharton MBA and CFA. “Understand that dilution is necessary and losing control over time can be positive towards achieving financial success.”

Examples of equity dilution

Let’s look at some examples of stock dilution in action:

• Startup scenario: Imagine a startup with 100,000 shares outstanding, and you own 10,000 shares—that’s 10% of the company. The company issues 20,000 new shares to raise money, increasing the total number of shares to 120,000. Your 10,000 shares now represent only 8.33% of the company.

• Employee stock options: Consider a startup with 200,000 shares outstanding. The company issues 20,000 stock options to employees as part of its compensation package. These options give employees the right to purchase shares at a set price in the future. If all employees decide to exercise their options, the total number of outstanding shares will increase to 220,000—and investor’s ownership percentage will drop.

• Convertible securities scenario: Let’s say an investor holds convertible notes set to convert at a 20% discount during the next funding round. If the value of shares goes up, note holders can convert to receive more shares for their investment than if they had purchased at market price—and this leads to a higher number of total shares.

How does equity dilution affect you (and your startup)?

Equity dilution isn’t just another financial metric—it directly impacts your ownership stake and control. Here’s how share dilution can impact you:

• Reduced ownership: The most direct impact of equity dilution is the reduction in the percentage of the company you own. This affects your potential earnings from a sale or dividends.

• Control over decisions: When you issue more shares, your voting power within the company diminishes. This can lead to scenarios where decisions are made without your agreement or even against your wishes—especially if new investors or groups hold different visions or strategies for the company.

• Employee morale and retention: Equity (in the form of company stock options) is a common way to attract and retain talent. However, if employees see their equity ownership percentages diluted too much, it might affect their motivation or loyalty to the company.

• Investment attractiveness: Issuing new shares can dilute existing equity, but it can also make your startup more attractive to new investors by showing growth and scalability. This can be a double-edged sword: you need to balance the attraction of new investment capital with the cost of diluted equity.

• Valuation considerations: Dilution affects the percentage of ownership and potentially the value of each share. If the company’s valuation isn’t increasing at a pace that outstrips the dilution rate, your financial stake could become less valuable over time.

How to better manage equity dilution

You’re in control of your startup and its equity. You want everyone to get a slice of pie, but you want to make sure there’s enough to go around (and that your slice isn’t compromised).

Equity dilution is often inevitable, but that doesn’t mean it needs to spiral out of control. Here are some ways to manage equity dilution:

• Plan your funding rounds: Plan how much capital you need and how it will affect your equity. This can help prevent unnecessary dilution and keep you in the driver’s seat.

• Use a cap table: Keep a detailed cap table. It’s essentially a spreadsheet or software that tracks share ownership and the dilution effects of new equity grants.

• Set favorable terms: Aim for terms that favor your vision for the company’s growth. This might mean finding investors who align with your startup’s goals or structuring deals that balance immediate funding needs with long-term equity retention.

• Consider alternative financing: Look into funding options that don’t involve equity, like debt equity, crowdfunding, or grants. These can be great ways to fuel your startup’s growth without slicing your equity pie into too small of pieces.

• Educate your team: Help your team understand how equity works and what dilution means for them. A team that’s informed about the ins and outs of their shares will feel more valued and involved.

• Review equity grants: Regularly review how much equity you offer employees and other stakeholders. Make sure these grants align with your company’s growth—too generous early on, and you might find yourself with less control later.

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