How equity dilution works for employees and venture capitalists

Have you ever wondered how startup equity dilution works? I'm here to walk you through the basics. When you first start a business, you'll likely have a few angel or seed funding rounds where you raise a few hundred thousand dollars or so in capital -- at an average valuation of $3 million -- which is known as your pre-money valuation (before the money).

It's crucial that the investors going in understand how their shares will be diluted over time, especially if they're going to be an employee! Throughout this article, I'll give a short but detailed explanation on how equity dilution works and I'll even throw in some charts as well.

Dilution is the decrease in the value of your ownership stake.

How equity dilution works for employees and venture capitalists Dilution is the decrease in the value of your ownership stake. This happens when a company issues new shares to raise money or because existing shareholders want to sell some of their shares. Employee dilution When you join a company as an employee, you usually start with a small ownership stake.

Over time, that ownership stake can get smaller if the company issues more shares or if other employees leave or are fired. The impact of employee dilution is often felt most acutely by early employees who initially had large stakes in the company. They could have been paid in stock options rather than cash and might have sold some of their shares early on as part of an employee stock purchase plan (ESPP).

Now they might have little left but vestigial options that won't pay off for years — if ever. Venture capital dilution In contrast, venture capitalists typically invest all at once and thus typically experience no dilution until after an IPO or acquisition event occurs (or both). In fact, VCs often negotiate for "super pro rata" rights, which means that they get more shares if any more are issued after they've invested.

Dilution happens when an investment is made or more equity is issued

Equity dilution is a topic that can be confusing for both investors and entrepreneurs. Here's how it works. The term equity dilution refers to situations where an investment is made or more equity is issued. This decreases the percentage of the company owned by each shareholder, usually because more people own the business than before.

For example, when a startup raises money from venture capitalists (VCs), it can dilute its existing shares. This is why many founders are wary of taking on VC money. It's also why they often turn down offers to sell some of their company's shares to employees in exchange for stock options.

Dilution happens when an investment is made or more equity is issued When a company gets funded, it often issues new shares in exchange for cash. This means there are now more people who own part of the business — including its founders and employees — but each person owns less than before because there are more shares outstanding.

As a result, each share has less value than before because there are more shares outstanding (and therefore more competition for them).

Issuing equity does not dilute existing shareholders unless it is done at a lower valuation than the existing shareholders purchased for.

Equity dilution occurs when a company issues new shares of stock to investors. This can happen in several ways, and it can be a good or bad thing for existing shareholders. When you buy stock from a company, you are buying an ownership stake in the company. As long as the number of outstanding shares remains constant, every shareholder owns equal parts of the business.

But when a company issues new shares of stock, it's possible for each shareholder's ownership stake to become smaller because more people own the company than before. There are two main types of equity dilution: normal equity dilution and reverse equity dilution. Normal equity dilution happens when a company needs capital to grow its business and raises money by issuing new shares to outside investors at a lower valuation than its previous investors paid for their shares.

Reverse equity dilution happens when an investor buys out other investors' stakes in a company, reducing those shareholders' ownership stakes while increasing his or her own stake in the business.

Employees should not be concerned with nominal dilution, but only real dilution.

After a startup raises its first round of venture capital, the amount of equity each founder owns is likely to be diluted. This is because, when an investor invests in a company, they own shares of that company. As more investors come on board, their shares will dilute the founders' ownership stake.

Employees should not be concerned with nominal dilution, but only real dilution. How much someone owns and how much they own after real dilution are two different things. Equity dilution happens with each new round of financing and has nothing to do with how many employees or options have been issued since the last financing round.

For example, if there are 100 shares outstanding prior to a new round of financing and you own 20 percent of those shares, you'd have 20 percent equity before any new investment was made. If a venture capitalist invested $1 million into your company at $5 million pre-money valuation and you raised $1 million total, then your ownership stake would be 16 percent post-money (20 percent x 92 percent).

To Sum Up

Employees work for a better salary and benefits, creditors work for a share of the future profits, and investors work for equity (of which they have none). In many ways, startup financing is similar to a marriage. You only want to dilute as much as you need to get your company off the ground, but once you do so you need to accept that your equity has been fractionalized.

The key takeaway here is to avoid introducing any sort of outside capital until your product has reached a stage where it has demonstrated real traction in the market. At that point you are likely to receive the best valuation on your company possible and will be able to hold on to more of your equity.