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dilution

Also called: equity dilution

The drop in the founders' ownership percentage when the company issues new shares to investors. Each funding round leaves the founders a smaller slice of the company and of any future sale.

Dilution is the drop in your ownership percentage when the company issues new shares to someone else, usually an investor. You keep the same number of shares, but there are now more shares in total, so your slice of the company gets thinner.

The quick formula: your new share = your old share × (1 − the share sold in the round). Two founders with 50% each who sell 20% to an investor end up with 50% × 0.8 = 40% each. A second round that sells another 25% takes each of them to 40% × 0.75 = 30%. Option pools for employees dilute the founders in the same way.

Dilution is not automatically bad: a smaller share of a more valuable company can be worth more money. The question is whether the investment makes the whole company grow by more than the share you give away, and what else comes with it: investors' rights, growth targets and the future rounds that each dilute you again. Bootstrapped founders avoid dilution altogether, which is why a modest sale of their company can still leave them with more money than a large exit after several rounds.

Example

Nina and Oscar own GarageDesk 50/50. In year 2 an investor offers 3,000,000 UAH for 20%, which values the company at 3,000,000 / 0.2 = 15,000,000 UAH after the investment.

After the deal each founder owns 50% × (1 − 0.2) = 40%. On paper each stake is worth 40% × 15,000,000 = 6,000,000 UAH. At the same moment a buyer offers 6,000,000 UAH for the whole company, which would be 3,000,000 UAH for each founder's 50% in cash. The paper value is higher, but it depends on the company growing into the 15,000,000 valuation, and the next round would dilute them again.

Common mistakes

  • Looking only at the percentage. Compare what your share is worth before and after, and how likely the higher valuation is.
  • Forgetting future rounds. One round rarely comes alone; model two or three rounds before celebrating the first.
  • Ignoring the option pool. Pools created before a round often come out of the founders' share only.
  • Mixing pre-money and post-money valuation. 3,000,000 for 20% means 15,000,000 post-money and 12,000,000 pre-money.