A Primer on Equity Dilution
When the founders of a company bring in new equity money, they are typically concerned that they may be giving away the store -- reducing their percentage ownership by too large an amount. The culprit is typically something called "dilution."
The concept of dilution is a major factor to consider in deciding upon a financing strategy. By definition, bringing in an equity investor means that that the new party will be taking part ownership of the company. So where does the newcomer's ownership interest come from? Very often, it comes out of the prior owners' chunk of the pie, meaning that the percentage ownership of each of the prior owners decreases on a pro rata basis. The prior owners don't necessarily give up shares. Instead, new shares are issued to cover the newcomer's position. The number of shares held by prior owners does not change. However that number of shares corresponds to a smaller percentage of the total number of shares. That decrease in the percentage interest is dilution.
Hopefully the newcomer's contribution will make the pie bigger, so that the value of the prior owner's adjusted percentage ownership is worth as much or more than the original larger percentage. Unfortunately, this is not always the case (particularly if, for example, business plan milestones were not met, and "accommodations" must be made in order to attract "new money"), and there is always the issue of governance and control.
In some cases, the newcomer will simply be given a number of shares based upon the value of the business, and the value of the newcomer's contribution (e.g., the newcomer pays $10,000 for $10,000 worth of shares). In other cases the newcomer may get a specified percentage ownership of the business entity. (This is the case used in the example below.)
So if the newcomer ends up with a specific percentage of the business after the dust settles, how can you determine the percentages retained by the original owners? In some cases, the original owners, in effect, renegotiate their relative percentages -- and agree how much each will contribute toward the newcomer's interest. In other cases, the percentages retained by the original owners are determined on a purely mathematical basis. The easiest way to understand the process is to think in terms of shares in the company. (In a corporation there will be actual shares. In other forms of entities there may not be -- the principals each own certain percentages of the entity. In those cases simply assume that each 1 percent interest corresponds to one share.) The relative percentages can be calculated using the following equations:
(New Shares Issued) = (Original Total Shares) x (Newcomer's Interest)/ (1- Newcomer's Interest)
(Principal's Retained Interest) = (Principal's Original Interest)/ (Original Total Shares + New Shares Issued)
Let's assume that prior to a New Owner coming on board, Owner One held 95 percent interest, corresponding to 95 shares and Owner Two held 5 percent interest corresponding to five shares, for a total of 100 shares. New Owner's interest will be 30 percent. Accordingly, when rounded to the closest whole number or 1 percent, as appropriate:
(New Shares Issued) = (100) x (0.30)/ (1-.30) = 43
(Owner One's Retained Interest) = (95)/ (100 + 43) = 0.66 (66 percent)
(Owner Two's Retained Interest) = (5)/ (100 + 43) = 0.04 (4 percent)
You can see that each time a new owner is added, the prior owners' experience dilution of their percentage ownership. This is a key concern that must be considered when obtaining financing your company with Other People's Money (OPM).
Sophisticated investors invariably review your business plan to determine if you are planning for future investment rounds. Why is that? The answer is that dreaded "dilution," the same risk you as a shareholder has in raising money in multiple rounds. Your own equity position, and that of each team member and each of the early investors, faces potential dilution from later rounds of new investors.
If the business does well, then that dilution may not be too bad. But the sophisticated investor knows that unless the business plan funding strategy is both well thought out and properly executed, the investment round after him, likely much larger and from a professional venture investor, presents the risk of substantial dilution of his or her equity percentage. The sophisticated investor will be particularly sensitive to the business plan's financial objectives and the likely timing and size of funding rounds, and will gauge the risk that the valuation at that later funding stage will justify an investment that enhances his stake, or that hammers it. Many investors also will want to make use of an anti-dilution provision to protect them from dilution in future financing rounds.
Perhaps most significantly, the amount of "equity money" that you raise can affect your ownership and control of the business. You need to plan in order to avoid a cash shortage, but if you raise too much "equity money" too early, you may unnecessarily dilute the ownership of your business. The cost (in terms of percentage ownership per dollar) is primarily a function of the valuation of your business at the time you seek "equity money." For that reason, you should correlate your fundraising with critical growth stages and milestones