How Dilution Works

How Dilution WorksSometimes founders will ask me the following question:

    “The founders stock will be equally diluted when we bring in new investment money, right?”

And sometimes they will ask me:

    “When the company raises money, do we give some of our shares back to the company? How does it work?”

Let me show you an example of how it works:

Bill and Paul form a software company. Bill gets 60% of the shares, Paul gets 40%.

They plan to issue 1,200,000 shares to Bill, and 800,000 shares to Paul.

Their lawyer also told them at the outset to adopt a stock option plan, representing 10-15% of the issued and outstanding shares, to get the adoption of the plan out of the way, and to have it available right away so that when they started hiring employees and independent contractors and board advisors they can grant options. They did that, and put 300,000 shares in the plan.

Immediately after the founding of the company, the cap table looks like this:

Bill 1,200,000 52.17%

Paul 800,000 34.78%

Pool 300,000 13.04%

2,300,000

When they go to raise money, the company will issue new shares out of its “authorized but unissued” shares. The founders won’t give back any shares.

What are authorized but unissued shares? These are shares the company has authorized in its articles of incorporation but not issued. In the above example, the company would probably have 10 million shares authorized. In this instance the company has only issued 2 million, and reserved 300,000 for issuance under the pool. So it has plenty of shares to issue to the investor. If the company sold 200,000 to an investor, the cap table would look like this afterward.

Bill 1,200,000 48.00%

Paul 800,000 32.00%

Pool 300,000 12.00%

Investor 200,000 8.00%

2,500,000

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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  • Christopher Pirnke

    It’s also important to note those instances where the agreement contains dilution provisions allowing the stock holder the chance to retain their percentage interest.

    • http://startuplawblog.com/joewallin Joe Wallin

      Yes. Anti-dilution is frequently misunderstood as well!

      • http://www.venturedocs.com Bo Sartain

        Two possible topics for you Joe: 1. The preemptive right to maintain and 2. Price-based anti-dilution protection from “down rounds”. I’ve written about price-based anti-dilution here: http://blog.venturedocs.com/?p=20

  • http://www.venturedocs.com Bo Sartain

    Dilution is good. It means the company is doing business. If the company is issuing options to employees, preferred or common stock to investors and warrants to strategic partners, it means the company has a lot going on and is doing business. This is a good thing. The key is to grow the pie. If the founders own a smaller % of the company after these transactions but the value of their stock is going up, everyone should be happy.

    • http://startuplawblog.com/joewallin Joe Wallin

      Yep. I agree Bo.

  • http://twitter.com/equitrend Equitrend Capital

    Is the option pool ever increased?

    • http://startuplawblog.com/joewallin Joe Wallin

      yep…very typical as a company grows…