Am I about to get diluted?

Editor’s note: A version of this question originally appeared on Reddit.‍

I was one of the first five employees hired at my startup. When I joined, they offered me 100K shares in stock options, and told me at the time that we were still too small to put a value on those stock options.

Now, a couple years later, we’re bigger and we’re getting ready to raise our first round of funding. What typically happens now? Do I get diluted? Do companies offer their employees more shares to compensate for the dilution? Is being an early employee an advantage if we’re going to get diluted anyway?‍

- Anonymous‍

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Dear Anonymous,

Long answer short: Yes, most shareholders in a startup get diluted when the company raises a fresh round of funding. Not necessarily everyone (more on that later), but most do. And that’s not necessarily a bad thing.

Let’s dig into the question. If your startup is getting ready to raise funding, you should be able to log into your stock options benefit administrator — for example, Carta — and see both your stock option strike price and the company’s current 409A valuation (also known as fair market value).

Startups are required to update their 409A valuation on a regular basis, typically at least once per year, and anytime there is a major event that changes the value of the company, such as raising a fresh round of funding.

The 409A valuation gives you a rough estimate of how much a single share of the company is currently worth. If there are 1 million shares with a 409A valuation of $1/share, the company is worth, theoretically, on paper, $1 million.

Your stock option grant — in this case, 100,000 shares — will have a strike price that does not change. This is how much it will cost per share to exercise, or buy, your stock options.

Typically, when a startup raises a new round of funding, the company’s board of directors will authorize the startup to issue new shares, diluting the existing shareholders (i.e. the founders, employees and existing investors).

However, a fresh round of funding often means a new, higher 409A valuation, which could also mean that the total value of your stock options rises, even as you’re being diluted.

To put it another way, would you rather own 10 percent of a 1-pound pie, or 1 percent of a 100-pound pie? With the metaphorical 100-pound pie, your percentage ownership of the total pie is comparatively smaller, but the absolute value of the slice is bigger.

As they’re being diluted, startup founders can retain control of their company by authorizing a special class of shares that hold more voting power-per-share than common stock. One high-profile example of this is Facebook, where Mark Zuckerberg controls the majority of the company’s voting power.

As an early employee, you may have been offered preferred (rather than common) shares in your original stock option grant — this is a good thing to check over with a financial professional.

Investors can include anti-dilution provisions in their negotiations that are designed to protect the value of their investments if a startup raises a down round, or where dilution will otherwise lead to a loss in investment value.

Employees very rarely have access to the same types of anti-dilution measures. Still, there are countless examples of early employees at fast-growing startups who see the value of their stock options rise considerably with each new round of funding. For those employees, there is certainly value in getting in on the ground floor, even if you get diluted on your way up.

- Vieje Piauwasdy, Director of Equity Strategy, Secfi

Do you have a question about your stock options? Email us at ask@secfi.com