Dilution: Overview, definition, and example
What is dilution?
Dilution refers to the reduction in ownership percentage and value of existing shares when a company issues new shares. This commonly happens when a business raises additional capital by selling equity, grants stock options to employees, or converts financial instruments like convertible debt into shares. As more shares enter the market, existing shareholders own a smaller portion of the company, which can impact voting power and financial returns.
Why is dilution important?
Dilution can significantly affect investors, founders, and employees who hold equity in a business. When new shares are issued, the value of existing shares may decrease because the company’s ownership is spread among more shareholders. This can impact voting rights, dividend distributions, and the overall financial stake in the company.
For example, if a startup raises additional funding by issuing 1 million new shares, early investors who previously owned 20% of the company may see their ownership drop to 15%, reducing their influence and potential earnings. Understanding dilution is crucial for making informed investment and business decisions.
Understanding dilution through an example
Imagine you own 10% of a tech startup with 1,000,000 total shares. The company needs more funding and issues 500,000 new shares to raise capital.
Before dilution:
- You own 100,000 shares out of 1,000,000 total shares (10% ownership).
After dilution:
- You still own 100,000 shares, but now there are 1,500,000 total shares, reducing your ownership to 6.67%.
Even though your number of shares hasn’t changed, your percentage of the company has decreased, meaning you have less influence in decision-making and potentially lower earnings if the company distributes profits.
An example of a dilution clause
Here’s how a dilution clause might appear in an investment agreement:
“In the event of any issuance of additional shares, each existing shareholder’s ownership percentage shall be proportionally reduced unless they exercise preemptive rights to purchase new shares. The Company reserves the right to issue new equity for financing, employee stock options, or other business purposes.”
This clause informs shareholders that their ownership percentage may decrease and outlines any rights they may have to maintain their stake.
Conclusion
Dilution is a key consideration for investors, business owners, and employees with stock options. While raising capital through new share issuance can help a business grow, it can also reduce existing shareholders’ ownership and influence.
For SMBs and startups, understanding dilution and including clear clauses in investment agreements helps manage expectations and protect stakeholders' interests. If you’re an investor or business owner, knowing how dilution works can help you make better financial decisions and negotiate fair terms.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.