date: 2021-06-14 11:38:40

Share dilution is simply a decline in the percentage of share ownership as a result of the company issuing new shares of stock or employee stock options, which “dilutes” the ownership share of existing stock owned by shareholders.

The new stock issued increases the total number of the company’s shares, however, it decreases the percentage of ownership for the old shareholders.

There is more than one calculation that needs to be done in order to understand the final percentage for old shareholders, but they are very simple if you just follow the correct steps.

Examples

Let us take a quick and easy example, let us say you are an owner of a company and have 1,000,000 shares (it is always recommended for startups to issue a high number of shares when incorporating your company so as to minimize any rounding up / down of the percentage of ownership). Now, what happens if you need to raise US$200,000 and based on your financial valuation that equates to around 20% of your company post valuation (Post valuation, simply means the valuation of a company after taking into account the investment made / capital increase). That basically means that your total post valuation was US$1,000,000.

First thing you need to know how many new shares you need to issue so that the new investor(s) would own 20% of the company.

The first step is to divide your number of shares by (1 minus the percentage of ownership the new investors would own). That means: 1,000,000 / (1-20%), which means 1,000,000 / 0.8, which equals 1,250,000 shares. That is the company’s new number of total shares. 

Second step, is to deduct that figure by your old number of shares. That means 1,250,000 – 1,000,000 = 250,000 shares. That means in order for the new investor to own 20% you need to issue 250,000 new shares.

A general rule is to always perform your financial valuation after incorporating the financial results after the investment was made / capital increase (i.e. post valuation).

This is the method followed by Front Figure, which removes the confusion of calculating the pre-valuation and then post-valuation. 

Going back to our example, based on the above scenario that means that currently the old shareholders own their original 1,000,000 shares (which now equates to 80% of the total number of shares) and the new shareholders own 250,000 shares (which equates to 20% of the total shares):

For simplicity purposes, let us call the above capital increase the seed round.

Continuing on the example above, after two years the company now wants to have another round of funding (let us call that the Series A round).

The company’s total valuation is now US5,000,000 post valuation after taking into account the cash that needs to be raised, let’s assume that’s US$1,250,000. Unlike the seed round, that equates to 25.0% ownership of the company. That means that the investor(s) that will now be investing the US$1,250,000 will own 25.0% of the company after the capital increase. 

In that sense, given that there are currently two set of shareholders prior to the new Series A capital increase required, both will be “diluted”.

So, going back to our two-step calculation, we need to divide your number of shares by (1 minus the percentage of ownership the new investors would own). That means: 1,250,000 / (1-25%), which means 1,250,000 / 0.75, which equals 1,666,666.67 shares. That is the company’s new number of total shares.

Second step, is to deduct that figure by your old number of shares. That means 1,666,666.67 – 1,250,000 = 416,666.67 shares. That means in order for the new investor to own 25% you need to issue 416,667 new shares (rounded up).

That means that currently the old shareholders and the seed round investors own their original 1,250,000 shares (which now equates to 75% of the total number of shares) and the new shareholders own 416,667 shares (which equates to 25% of the total shares). As shown in the table below, on a standalone basis, the original (old) shareholder now owns 60% of the company, while, the seed round investors now own 15.0%:

Notice, that in the seed round the old shareholders let go of 20% of the shares, while, in the second round they let go of an additional 25% shares of the company (total 45.0%), however, based on the current situation the shareholders now own 60.0% (which means that effectively they let go of only 40.0% of the company).

That is obvious because in the second round the shares being diluted were both the original shareholders shares and the seed round shareholders shares, not only their shares.

Summary

In summary, if you are following the two steps mentioned above every time you issue new shares and are organized in keeping your cap table updated, you will not have any confusion in calculation the percentage of shares of any shareholders, including the original shareholders share percentage.

Do you need to value your company? Check out Front Figure. It is quicker and more cost effective compared to other traditional methods.

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