As startups grow and seek funding, understanding equity dilution is crucial for both founders and early investors. But what exactly is equity dilution, and why does it matter?
What is Equity Dilution?
Equity dilution happens when a company issues new shares, reducing the ownership percentage of existing shareholders. This often occurs during funding rounds or capital raises to secure capital for growth, product development, or expansion. While essential for growth, equity dilution significantly impacts founders and early investors.
Implications for Founders and Early Investors
For most tech startups, equity dilution is inevitable. Ideally, dilution should coincide with a higher company valuation so that the actual value of the investment remains the same or increases. To better appreciate this, let us consider the dilution impact of a subsequent fundraising at a higher and lower valuation in a scenario where a startup is initially valued at $100,000 with 100,000 units of shares and investor A holds 10% of the startup ($10,000/ 10,000 units of shares).
| Description | Higher Valuation Scenario | Lower Valuation Scenario |
| Pre-money valuation | $150,000 | $90,000 |
| Additional fund raised | $50,000 | $50,000 |
| Price per share | $1.5 $150,000
100,000 |
$0.9$90,000
100,000 |
| Number of shares issued to new investors | 33,333 units$50,000
$1.5 |
55,556 units$50,000
$0.9 |
| Total issued shares post-money | 133,333 units (100,000 + 33,333) | 155,556 units (100,000 + 55,556) |
| Post-money valuation | $200,000 ($150,000 +$50,000) | $140,000 ($90,000 +$50,000) |
| Investor A's stake post-money (%) | 7.5%10,000X 100
133,333 |
6.4%10,000 X100
155,556 |
| Value of Investor A's stake post-money | $15,000 (10,000 X 1.5) | $9,000 (10,000 X0.9) |
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