How Does Dilution Work?
The way dilution works is commonly misunderstood by entrepreneurs we meet.
Often times, entrepreneurs believe that there are a fixed number of shares in a Company’s ownership structure, and that they need to be pre-allocated on day one. So, with that assumption, we often meet with entrepreneurs that have decided how many shares to give themselves as founders, then how many to allocate to future investors, and future employees. Or, the founder allocates all of the shares to themselves, and assume that their shares get reduced when a new investor comes into the picture (i.e. they give their shares to the new investor, thus reducing their position in the Company).
That understanding is incorrect though.
When we incorporate a company, we most often set an unlimited number of authorized shares.
We issue the initial shares to the founders. Then when we need to issue shares to investors or employees along the way, we issue brand new shares from the treasury of the company. These aren’t being transferred from one place to another, they’re being newly issued. As a result, the founders see no change in the number of shares they hold.
Dilution occurs because the total number of shares in the company has increased, while the number of shares held by each person has remained the same.
With an investor, for example, it is important that the shares be issued by the company itself, and not simply transferred from a founder. This way, the money paid for those shares is going to the company itself, and not to a founder directly.
PRE-Money Cap Table Example:
Founder A - 5,000,000 shares (50%)
Founder B - 3,000,000 shares (30%)
Founder C - 2,000,000 shares (20%)
POST-Money Cap Table Example:
Founder A - 5,000,000 shares (41.67%)
Founder B - 3,000,000 shares (25%)
Founder C - 2,000,000 shares (16.67%)
INVESTOR - 2,000,000 shares (16.67%)
Ink LLP is a business law firm that acts as strategic counsel to ambitious entrepreneurs, investors, and high-growth companies. Contact one of our lawyers to discuss your business and how our team might be able to help you tackle the challenges of your business and the opportunities for growth.
This information is provided for informational purposes only and is not legal advice.