When it comes to dilution, the commonly used “pie slice” metaphor rings loud and clear. Creating equity shares is like cutting up ownership of a pie into multiple pieces. Dilution is when you cut those pie pieces into smaller and smaller pieces, leaving everyone with smaller fractions than they had before.
And generally speaking, we don’t like when pie pieces get smaller. This is the consequence of equity dilution.
Fundamentally, dilution is the reduction of equity stake for existing shareholders.
Take for example a shareholder who owned 3% of the company through the ownership of a single equity share. If the company chooses to issue 10x more shares than before, that owner’s single share would now be worth only 0.3% of the company.
When equity stocks get diluted, the proportion of the company that the shareholder once owned diminishes. Unless that shareholder is able to increase the volume of their holdings by the same rate, they are inherently left with less to skin in the game.
Why Do Companies Choose to Dilute Their Stock?
Usually, companies choose to dilute stock because expanding their investor pool can mean more potential for operational growth. As a private company grows, it can be met with new capital needs and funding interests that can expand its cap table. But because ownership of a company is limited to 100%, bringing on new shareholders means creating more shares.
All that said, dilution is not often the sign of an ideal situation. Rather, it can be the sign of a company that needs increased capital to keep operating, or one that needs to start bringing on more investors because an earlier round of capital had run dry. While these scenarios are not always the case, explaining the rationale behind dilution to existing shareholders can be a challenge for CEOs and CFOs.
For private companies in which employees have a large stake in the company, equity dilution can be an easier sell. Employees in private companies are less concerned with immediate stock prices, so reconfigurations of their stock ownership do not necessarily show tangible loss. Instead, employees of growing companies might see dilution as the effect of growth and future profitability. Expansion could make an employee’s shares worth more in the long run.
Dilution can affect not only shareholders, but also the company’s value at large. When dilution occurs for a company, its earnings per share can become reduced. Earnings per share (EPS) is profit divided by the outstanding shares of its common stock, and therefore an indicator of a company's profitability.
In the public markets, this can lead to a drop in stock price. For private companies, their profitability is often tied to valuation; as they move deeper down the transaction funnel, a reduced EPS can dissuade future investors and partners.
There are a wide range of ways that companies can avoid negative consequences of equity dilution and continue to build their business.
It comes up so often: work with the right people who share your vision, and your decision-making will be championed. For rounds of initial funding, founders should look for investors who share their business goals. As a company grows and expands, restructuring is always an option. Having like-minded investors on your team makes these decisions around dilution easier to make, and more fruitful.
Generally speaking, the fewer the investors, the better. Dilution is less likely to lead to monetary losses or ruffle feathers for larger investors when there aren’t as many of them. Companies that are spread thin across many investors might face more challenges when it comes to equity dilution. Each investor might be more affected by diminishing returns.
Dilution Protection refers to contractual agreements that prevent dilution from ever happening. Say an investor owns 20% of a company, and now that company wants to go through a new funding round. In order to stave off any losses that come from potential dilution, the company might be contractually obligated to sell discounted shares to the existing investor. This is a common scenario in venture capital.
Since lack of operating capital is a major driver for seeking new funding (and therefore possibly creating dilution), it’s important companies manage their cash flow effectively as they scale. Dilution is not always avoidable, but its effects can be curbed for companies in good financial condition.
Scaling up can be a little chaotic. Not only are you onboarding new vendors (and having to pay them ontime!), but your capital situation might also be in flux.
Settle helps companies save their time and money — and, in many ways, equity. By using Settle’s payment services, you are able to finance your working capital more strategically. This means you might be able to evade extra fundraising rounds that you actually don’t need, and therefore you’re able to hold onto more of your business. Sometimes all it takes is improved systems to ensure your cash flow is moving appropriately, and that you maintain your equity stake.
Settle helps payers and vendors alike with cash flow management, invoicing, and more in order to streamline your finances. Settle helps companies save their time and money — and, in many ways, equity.
Sources:
The Dangers of Share Dilution | Investopedia
Equity Dilution For Founders- How To Keep From Getting Fully Diluted | JonathanHung.com
