Startup equity dilution: What it is, when it happens, and how it affects you
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When a startup achieves a successful exit, the total exit value is distributed among all equity holders. For employees with stock options, your potential ownership stake depends on the number of shares you own as a percentage of the total company stock.
Dilution can affect the size of your ownership stake — so let’s explore what dilution is and why it matters.
Dilution occurs when a company issues new shares of stock, increasing the total share count. While you still own the same number of shares, your percentage ownership of the company decreases.
For example:
Dilution is a common occurrence with startups but isn’t always a cause for concern — more on that below.
Shareholders’ percentage ownership can be diluted in several scenarios, especially during fundraising rounds.
Startups often sell new shares to raise money to propel the company’s growth and/or pay down debt. When new shares are issued, existing shareholders’ stakes are diluted.
Preferred Shares Insight: Employees and founders typically receive common stock, while investors like VCs are issued preferred stock with more favorable terms. Even if only preferred shares are issued, common shareholders’ percentage ownership is diluted.
Dilution can also happen as part of an IPO. When a company goes public, new shares are often issued to raise capital.
As an existing shareholder, your stake can also be diluted when:
As long as your company’s valuation growth outpaces dilution, the value of your exit gains remains positive.
In other words, if the relative size of your slice shrinks (dilution), you can still come out ahead if the overall size of the pie grows sufficiently (increased valuation). Fortunately, this is usually the case for startup employees.
Let’s return to our example:
This may feel bad, but it doesn’t need to be. Your stake is halved but imagine if the new investments let your company quadruple its exit value, so your potential gains have actually doubled.
Here’s how that would work:
When all goes well for a startup, it will have a higher valuation in each subsequent round of financing. However, a “down round” can happen. That’s when a company sells stock at a price per share below the price it sold shares in an earlier financing round, presumably resulting in a lower valuation.
For example, Airbnb’s $1 billion fundraise in April 2020 valued the company at $18 billion, below its previous internal valuation of $26 billion.
It’s also worth noting that dilution can reduce your voting power. If your shares come with voting rights, you’ll be granted a certain number of votes per share. Voting typically gives you the ability to elect directors to the board and express your views about major corporate decisions, such as mergers and acquisitions. As your stake in the company declines, so may your voting power.
Use our Stock Option Tax Calculator to see how much you could save by exercising early. Sign up for free to access tools that help you maximize the value of your equity and plan for dilution effectively.