What is Equity Dilution? A Guide

Equity dilution occurs when existing shareholders’ ownership percentages dwindle following the company’s decision to issue additional shares. As these new shares enter circulation, the stake of each diminishes, even if the additional funding acquired raises the value of the business. Functionally, this doesn’t just mean potentially lower returns for shareholders, but it may also result in less decision-making influence when asserting shareholders’ rights. As a result, this is an important topic for global entrepreneurs, investors, and other key business stakeholders to understand.

This doesn’t necessarily mean that equity dilution is inherently negative in all cases. Rather, in many ways it’s a quite natural part of growth. That said, the more owners and shareholders understand about the implications, the more equipped they are to weigh these and make informed long-term decisions.

We’ve created this guide to dive a little deeper into the concept of equity dilution. We’ll explore the causes of dilution, its implications for stakeholders, and what needs to be considered when issuing new equity. Importantly, we’re taking a global perspective, rather than being bound to local jurisdictions—ensuring relevance no matter where you are in the world.

Understanding the Basics of Equity Dilution

Simply put, when a company increases the number of shares outstanding, dilution of equity occurs. This is typically the result of issuing new shares with the intention of raising capital or compensating certain stakeholders. In essence, when the total share count rises, each existing shareholder’s stake in overall ownership reduces.

So, why would companies take action that has these potential consequences? There are various common reasons. Supporting fundraising rounds is among the most frequent, in which companies will issue new equity in exchange for capital in order to finance operations or growth. Another reason is companies occasionally offer employee stock option plans (ESOPs) which can contribute to equity dilution if they’re exercised, sometimes long after initial issuance. Convertible securities can also play a role by transforming into equity at predefined stages, often even at a discounted price to the current market value.

In these situations, one vital distinction is between pre-money and post-money valuations. Pre-money focuses on the value of a company prior to new investment being added, while post-money incorporates the value of new capital. When there are misunderstandings about these figures, founders and early investors can experience levels of dilution they may not have expected.

Key Scenarios That Lead to Equity Dilution

It’s worth getting a closer look at the main scenarios that can lead to dilution. These include:

• Fundraising rounds – For early-stage startups, equity dilution is common during the fundraising rounds—Seed, Series A, Series B, and so forth. This is because each funding round often involves issuing new shares to investors. 
• Issuance of stock options – Some companies will grant stock options to employees or maintain ESOPs, which can also drive dilution. These instruments can be useful for talent retention and engagement, but they also expand the number of shares in circulation when they’re exercised.
• Convertible notes – Convertible notes and Simple Agreement for Future Equity (SAFE) tools can be a useful way to gain capital while deferring potential dilution to a later date. However, this can mean that eventual equity dilution affects the ownership structure on terms that are more favorable to the investor than to the company and other shareholders.
• Mergers or acquisitions – Mergers and acquisitions (M&A) can involve share swaps or stock-based deals, which can dilute equity for existing shareholders. Merger and acquisition consulting providers are useful tools for effectively assessing whether the temporary dilution of ownership percentages are well balanced by the potential for boosting long-term value.

Examples of Equity Dilution in Practice

As a way to illustrate the mechanics of dilution, it can be useful to imagine that a company has 100 existing shares that are owned by founders and investors. This company might then issue a further 50 shares to a new investor, which bumps the total shares to 150. The result of this is that existing shareholders now find their collective ownership percentage reduced from 100% to 75%. Their number of shares hasn’t changed, but the stake in the company those shares represent has been diluted.

This may not necessarily mean value has been lost. The new investment can boost the value of each shareholder’s stake, and each share still has the potential to grow in value.

Consider a case study in which a startup is raising capital through Series A funding. It might issue 25% of its post-money equity to new investors.  This dilutes early shareholders’ equity, while still bringing in essential funding to support growth. This potentially increases the startup’s long-term valuation expectations and provides resources that support scaling or even innovation that pays off for everyone later. As a result, dilution can represent a strategic trade-off; relinquishing percentages of control in exchange for much-needed capital.

How Equity Dilution Affects Founders and Early Investors

There are several key ways that equity dilution affects founders and early investors, including:

• Control reduction – As the percentage of ownership declines, a degree of control over strategy and operations can also be lost. This is particularly the case when voting rights are tied to the number of shares held.
• Valuation and dividends – There can be financial implications caused by dilution, with the potential for the value of each share or the returns on exit valuation being reduced by the additional shares. While this isn’t necessarily guaranteed, it needs to be taken into account when developing frameworks such as dividend policy.
• Need for balance – introducing new shares means that founders and managers need to carefully manage the trade-offs between dilution and growth capital. Strategies for evaluating risks and negotiating with existing shareholders will be additional considerations.

Some of the negative effects of dilution can be mitigated through protective clauses, like anti-dilution provisions that should be negotiated during early funding rounds. Though these can be quite complex, they safeguard the interests of founders and early backers while allowing room for capital acquisition.

Managing and Mitigating Equity Dilution Risks

Proactively managing equity dilution risks is key to retaining investor confidence and strategic resources. Among the most effective approaches is the use of pro-rata rights. These are terms built into contracts that enable existing investors to participate in future funding rounds, thereby providing opportunities to retain their ownership percentage.

The severity of dilution can also be influenced by the terms of valuation. By achieving a high valuation during a fundraising round, fewer shares usually need to be issued to gain the same capital amount in future, which can limit the extent of dilution.

Other strategies that can help here include staged financing, which limits the dilution that occurs in each funding milestone. Using capped convertible instruments can also place a ceiling on conversion values. Both of these methods can delay pricing until the company is stronger, which, in turn, mitigates potential premature valuation discounts.

Companies may also utilize legal structures, such as special voting rights or carefully-designed governance frameworks, that preserve the decision-making power of founders and early investors.

Equity Dilution vs. Brand Equity Dilution

While equity dilution and brand equity dilution share similar terms, they are different concepts.

	Shareholder dilution	Brand perception dilution
Definition	Equity dilution is the reduction of existing shareholders’ ownership percentage	A decline in the public perception of a brand’s profile or reputation
Cause	New shares are issued when funding is sought	Most commonly, a combination of poor partnerships, inconsistent messaging, and brand overextension
Impact area	The company’s cap table, governance structures, and/or investor returns	Consumer sentiment, market positioning, and competitive pricing power
Affected aspects and parties	Founders, investors, and shareholders	Internal stakeholders, company reputation, consumer perception

FAQs

What is dilution of equity in a startup?

When new shares in a company are issued, this can reduce—or dilute—the ownership percentage of existing shareholders.

Can dilution be avoided?

Not entirely, although it can be managed through careful funding strategy and shareholder protections.

What is dilution of brand equity?

It’s the decrease in brand value resulting from entering unrelated markets or lowering product quality, among other actions.

Does dilution affect company valuation?

Not directly; it affects shareholder percentages. The company’s valuation depends on the market and operational factors.

Why do companies choose to dilute equity?

It can raise capital for growth, incentivize employee engagement, and support strategic transactions like stock for stock mergers.

References

Ganti, A. (2024, November 5). Employee Stock Ownership Plan (ESOP): What It Is, How It Works, and Advantages. Investopedia. https://www.investopedia.com/terms/e/esop.asp 

Westaway, K. (2023, January 6). Understanding SAFE Agreements: Benefits And Risks For Startups. Forbes. https://www.forbes.com/sites/kylewestaway/2023/01/06/understanding-safe-agreements-benefits-and-risks-for-startups