Equity Dilution
When begin with a company, you typically own 100 percent of the company or the percentage you and your cofounders agree to. To build the business further, you probably need to raise additional capital.
An easy way to do that is selling part of your ownership in the company, called equity, to an investor. You may also give away some equity to early team members as part of their compensation.
Equity dilution results from new share issues. That means you are adding more shares into the pot, which could reduce the percentage of ownership held by you and your original stakeholders.
It could dilute ownership, but it is a very common step that most businesses must take to get the funds or talent needed to move your business forward. But if not properly controlled, dilution can get out of hand.
Pre and Post money valuation:
Pre-money valuation is said to be the value that the company has without the newer, external funding and also without consideration of its most recent funding round. Best would be to say how much a startup might be worth before it ever started receiving any investments into the company.
While pre-money valuation refers to how much money is worth a company before receiving investment money, post-money relates to the worth of a company after receiving its investment money.
Post-money valuation includes outside financing or the recent capital injection. It is essential to identify one because they form the most critical valuation concepts with regard to any company.
What occurs when there is equity dilution?
Now that we’ve discussed equity dilution, let’s take a look at what can go wrong if you don’t manage it well and end up getting over-dilated.
Too much dilution will dilute the equity and control of the founders, below 50% may put the decision-making and voting power in jeopardy.
It means that more shares come out without a greater startup value, and hence each share-and, in turn, each stakeholder’s equity-loses value.
High dilution would chase away potential investors because it lowers earnings per share, and it is perceived to yield lower returns.
Dilution can irritate shareholders by watering down the worth of their shares and power, which could give rise to conflict.
Advantages and disadvantages of stock dilution:
Stock dilution usually is viewed negatively because there is a reduction in ownership percentage, but it can also have strategic advantages for existing shareholders.
Advantages:
The most evident benefit of stock dilution is the injection of capital. The funds raised by issuing new shares can be used to fund growth and expansion, invest in new projects, or pay off debt.
This means that there must be a proper use of the capital so the net worth of the company will increase. So, even if there is a lower percentage of ownership by the capital, the value of the existing shares may still rise.
New shares also may attract new investors who apart from bringing new capital, would bring valuable resources, connections, and expertise.
Disadvantages:
The most obvious weakness in stock dilution is that it reduces the ownership percentages of the existing shareholders, wherein possible voting power and influence over corporate decisions are also claimed to have been diminished.
Increase in the share issued by a company increases the number of shares that its earnings are spread over; thus, it can reduce earnings per share.
Potentially, this dilution of the earnings could affect the price that the market puts on shares in the company and its perceived worth.
How to mitigate share dilution:
Here are some strategies that may help to mitigate share dilution:
Avoiding an Overly Large Option Pool:
Creating an option pool can help attract and retain talent, but the pool should avoid an oversized size, as this may lead to unnecessary dilution. The option pool size should be aligned with the company’s growth and needs of employees.
Leverage the power of equity dilution:
With this kind of dilution modeling, you would be able to predict how successive rounds of funding as well as other events will impact your ownership percentage. Tools and techniques, including equity calculators and financial modeling software, aid this process. The tools also make clear precisely how the scenarios play out, so you can enter fundraising and equity grants with more informed decisions.
Learn About the Importance of Timing in Fundraising:
Thus, rushing into rounds of funding without considering the dilution consequence can bring about a crushing erosion of your ownership interest. In other words, one needs to be prudent about the fundraising decisions made and their timing.
Conclusion:
Businesspeople typically experience dilution during their operation, and often this is a means to acquire growth and expand business. However, this should be done with caution not to sustain high amounts of dilution as these may result in loss of control and depressed shareholder value. The entrepreneur is aware of how the equity advantage and disadvantage reflect in diluted terms and then strategizes how to circumvent large option pools and how to use dilution modeling.