When we spoke about the different types of investment I raised the subject of share dilution and promised that I’d explain it in detail later. For the purposes of this article when I refer to shares, I am talking about common shares, not preferred shares (You are going to cover the difference one day right? - Ed)

Well it’s later, so here goes.

Shares are units of ownership of a company, or equity in the company. If you were to found a company by yourself you would own all of the shares and hence the whole of the company. If you started a company with two other people and issued three shares, one for each of you, you would all own one third of the company.

What are diluted shares?

When you come to raising money the concept of dilution becomes central. It refers to the dilution of ownership of the existing shareholders when new shares are issued. Why are new shares being issued? It’s because you raise money for the company by selling those new shares to investors. If you were selling existing shares the money would go to the shareholder, which benefits them, but doesn’t put money into the company.

The amount you raise is the new share price multiplied by the number of new shares you issue. To expand on our example above each of our three founders owned 33.3% of the company, and had the equivalent voting rights. However if the three founders wanted to raise some investment into the company in order to scale quickly, they might look to give away 25% of the company’s equity in return for the investment. That would mean they would issue one more share, and that would go to the investor.

Each of the now four shares still have equal value, but when there were only three, each was 33% of the company. Now there are four, each is 25% of the company.

By adding an additional share the original founders have diluted their ownership of the business. However if the new share price is high enough the value of their shares may have risen, after all 25% of £200,000 is worth more than 33% of £100,000.

Let’s take a more realistic example:

Three founders share a business equally holding 1,000,000 shares (each with a nominal value of £0.000001, a fairly typical arrangement).

They want to raise £60,000 so go out to investors. They set a pre-money valuation of the business at £675,000 (based on their claim of value generated so far).

They sell 266,669 new shares to new investors at a price of 22.5p each (£0.225 * 266669 = £60k) Since there are now 3,266,669 shares in the company their original 1,000,000 shares now represents 30.6% percent of the company rather than 33.3%. However the business is now worth £735,000 and the value of their shareholding has risen from £1 to £224,000!

What happens when shares are diluted?

The key thing to understand about share dilution is how it affects majority ownership of the company. In our example above, while none of the 3 founders owns a majority of the shares, together they still own over 90%. Some issues (for example the issuance of new shares) require an investor majority. As the ownership level of the founders reduces, the influence of other shareholders increases. Different levels of share ownership also bring different rights (a topic for another article) but the key thing is to keep an eye on the majority..

The other thing that is worth mentioning is that each share, in additional to its voting rights, also brings with it a share of the profits of the company should it issue dividends. Startups often don’t issue dividends but more established companies typically do. So when shares are diluted, the portion of the profits are also diluted, although if the business is becoming more profitable then the share of profits may still increase.

Why share dilution can happen

There are all sorts of different reasons why share dilution may happen. We’ve already covered equity investment in the company, but other situations may also create dilution.

It’s typical for employees in early stage companies to be offered share options, those shares are also dilutive. And if a company acquisition is made, shares in the purchasing company are sometimes offered as part payment to the shareholders in the company that has been purchased.

In effect, any time new shares are issued, then existing shares are diluted.

Is share dilution a bad thing?

Well that depends entirely on your perspective. If what you care about is the ability to make a decision about your company without having to involve anyone else then diluting your power to do that is by definition a bad thing. But when it comes to the base finances it may not be that bad a thing at all.

Diluted earnings by share

When you look at share earnings as a percentage of the profits then share dilution has a significant impact on earnings. But if you look at the amount of earnings in monetary terms then it is rarely that clear cut.

As a rule reasons for issuing extra shares are considered positive for the company. Bringing in investment signifies future growth, and so the raw value of any share will increase.

Let’s go back to our example from earlier.

Our three founders all have 33.3% of the company, and so if we value the company at £1M they all own £333,333.33 in monetary terms. If that company makes 10% profit which is paid out as dividends (not a likely number, but nice and easy for the maths) then each of the three shareholders will take £33,333.33 in dividends before tax.

However if an investor believes the company will grow, and offers £500,000 for their 25%, then it would be fair to value the company at £2M, meaning each 25% share is worth £500,000. A lower percentage, but a higher figure.

If that investment is used wisely, and the company does double in size (but surprisingly still makes exactly 10% profit) each of the now four shares would attract a dividend of £500,000.

Again, the shares have been diluted, but the money has grown.

So in the simplest sense, if the reason for the dilution increases the value of the company, the dilution of share value may not reflect in the financial value of the shares.

Alternatives to share dilution

Share dilution mostly arises out of equity investment and typically makes sense in a company that is growing and building value. If the shareholders don’t wish to dilute it may be possible to raise money through, for example, raising debt.

It sometimes happens that shareholders will sell some of their existing shareholding. When this occurs the money goes to the existing shareholder, not to the company. This is sometimes referred to as a secondary sale and is sometimes used to allow founders to cash out before an IPO and without diluting the company.

The dangers of dilution

There are no hard and fast rules about dilution, but you need to be aware of the possible impact share dilution can have on your position within your company. It is not unheard of for a founder to find themselves being forced out of the role they had in their own company by investors who now had a controlling share.

You need to be aware that with very few exceptions, investors are not there to protect you, they are there to make money, and while a small percentage of a fortune is still a lot more than all of nothing, dilution can have a huge impact on you and your business.

Dilution is a complex subject, and there are subtleties I don’t have the space to cover here. You should definitely be aware of and take professional advice before making big decisions that may trigger it. But as long as you keep in mind how it affects your majority, and keep building the value of your company it’s nothing to be afraid of.

What you need to know about diluted shares