What does stock dilution mean for startups? Here’s a simple guide
One of the few areas of startups that techies or founders get wrong is their understanding of stock dilution, also called share or equity dilution, and how to calculate dilution.
Dilution is the result of a give and take: the founders of a company have the shares, and the investors have the money and resources. When a founder trades the company’s shares for investors’ funds, the investor is allotted equity holding; and while a founder still maintains his or her number of shares, their percentage falls.
A startup will not be able to escape stock dilution except it has no investor or does not give out shares to employees.
Here are 10 simple outlines of how stock dilution works:
1. Let’s say two individuals come together to form a new company which starts with one million shares. At the beginning, the founders own all shares in the company (100% ownership). Founder A owns 500,000 shares, while Founder B also owns 500,000 shares.
2. Two years later, an investor agreed to fund the startup, and valued the startup to be worth $20 million. This $20 million is called pre-money valuation.
3. This means that each share of the total one million shares owned by the founders is worth $20.
4. The Investor decides to invest $5 million, having it in mind that one share in the startup is worth $20. This means the investor will get 250,000 shares in the company with his $5 million.
5. When the founders agree to the investment of $5 million, due diligence will be done and agreements signed to seal the deal. Immediately the new investment comes in the post money valuation of the company then becomes $25 million.
6. The 250,000 shares that will go to the investor will be created separately and will not be deducted from the shares of the founders.
7 This means that the founders will still have 500,000 shares each, while the investor will have 250,000 shares. This means that the number of shares of the company is no longer 1 million. It is now 1.250 million (one million and two hundred and fifty thousand) shares.
READ ALSO: Nigerian stocks slide further as investors cash out
8. The only thing that will change is the percentage ownership. The investor now has 20 per cent of the startup while the other two founders own 80% shares of 1.250 million shares of the company. This means Founder A now has 40 per cent while Founder B now has 40 per cent.
9. This means that the shares of the founders were diluted by 20 per cent.
10. Gradually as you raise more funds and depending on the terms you agree to, dilution may get more complicated but the above example is a foundational example of how stock dilution works.
Victor Opatola is a tech-lawyer.
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One of the few areas of startups that techies or founders get wrong is their understanding of stock dilution, also called share or equity dilution, and how to calculate dilution.
Dilution is the result of a give and take: the founders of a company have the shares, and the investors have the money and resources. When a founder trades the company’s shares for investors’ funds, the investor is allotted equity holding; and while a founder still maintains his or her number of shares, their percentage falls.
A startup will not be able to escape stock dilution except it has no investor or does not give out shares to employees.
Here are 10 simple outlines of how stock dilution works:
1. Let’s say two individuals come together to form a new company which starts with one million shares. At the beginning, the founders own all shares in the company (100% ownership). Founder A owns 500,000 shares, while Founder B also owns 500,000 shares.
2. Two years later, an investor agreed to fund the startup, and valued the startup to be worth $20 million. This $20 million is called pre-money valuation.
3. This means that each share of the total one million shares owned by the founders is worth $20.
4. The Investor decides to invest $5 million, having it in mind that one share in the startup is worth $20. This means the investor will get 250,000 shares in the company with his $5 million.
5. When the founders agree to the investment of $5 million, due diligence will be done and agreements signed to seal the deal. Immediately the new investment comes in the post money valuation of the company then becomes $25 million.
6. The 250,000 shares that will go to the investor will be created separately and will not be deducted from the shares of the founders.
7 This means that the founders will still have 500,000 shares each, while the investor will have 250,000 shares. This means that the number of shares of the company is no longer 1 million. It is now 1.250 million (one million and two hundred and fifty thousand) shares.
READ ALSO: Nigerian stocks slide further as investors cash out
8. The only thing that will change is the percentage ownership. The investor now has 20 per cent of the startup while the other two founders own 80% shares of 1.250 million shares of the company. This means Founder A now has 40 per cent while Founder B now has 40 per cent.
9. This means that the shares of the founders were diluted by 20 per cent.
10. Gradually as you raise more funds and depending on the terms you agree to, dilution may get more complicated but the above example is a foundational example of how stock dilution works.
Victor Opatola is a tech-lawyer.
Support PREMIUM TIMES’ journalism of integrity and credibility
Good journalism costs a lot of money. Yet only good journalism can ensure the possibility of a good society, an accountable democracy, and a transparent government.
For continued free access to the best investigative journalism in the country we ask you to consider making a modest support to this noble endeavour.
By contributing to PREMIUM TIMES, you are helping to sustain a journalism of relevance and ensuring it remains free and available to all.
Donate
TEXT AD: Call Willie – +2348098788999
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