Equity dilution guide for startups

What causes equity dilution?

Raising capital through equity funding is one of the most common causes of dilution. Business owners may issue stock to new investors in return for capital. The company's value doesn’t change, but the issuance of new shares reduces the value of existing shares. The hope is that the additional capital could increase the company’s valuation to offset the effects of dilution.

Some companies offer future equity in a funding round. Simple Agreements for Future Equity (SAFE) and convertible notes are examples. They are executed on a future date outlined in the agreement. The investment capital is received when the agreement is made. The execution date of the note is typically set for a future date when the company anticipates potential changes in valuation.

Other events that can cause dilution are acquiring a new company by offering common shares, executing employee stock options, or issuing new stock in an initial public offering (IPO). It can also happen with debt financing. Some companies offer convertible securities to lenders when taking out a business loan. Executing those notes can cause equity share dilution.   

A less common cause of dilution is a stock split. It happens when the market price of a stock hits a certain level, and the company wants to divide each share in half. The lower price per share counts as dilution, even though the shareholders’ equity stake doesn’t change. Splits are typically done with common stock, so preferred shares are unaffected.  

How does equity dilution work?

Let’s assume that your small business is valued at $1 million and has issued 10,000 shares of stock, each worth $100. Issuing 2,000 new shares to take on an equity partner will reduce the value of your company's stock to $83.33 per share, this is because increasing the total number of shares typically causes dilution. Your ownership percentage would likely also change.

Apply this same concept to convertible notes. Those shares don’t exist until the note is executed. When that happens, existing shareholders will see the value of their stock decrease because the number of outstanding shares increases. Each slice is slightly smaller when the pie is cut into more pieces. 

Reduced share prices produce lower earnings per share (EPS), which could be in dividends or stock market gains for public companies. Voting rights could also be diluted if new common stock is issued. Preferred stock doesn’t typically come with voting rights, and it can come with anti-dilution provisions, making it a preferred award in an equity investment deal.   

A private company typically has fewer market-based options to reverse dilution. Public companies may influence their stock price when they issue shares or offer to repurchase shares when the open market value is low. The latter sometimes occurs before a fundraising round to increase voting power. Repurchasing may also be associated with potential acquisitions or mergers.

Legal and regulatory framework of equity dilution

Companies are required by law to disclose the issuance of new shares that could cause dilution. This can be done in financial reports or at shareholder meetings. Public companies are required to file a 10-K or 10-Q report with the SEC. Whatever the method, shareholders should be informed if the value of their shares is about to go down. 

The board of directors or shareholders should vote on decisions that dilute stocks. This is known as corporate governance. It's in the company's best interest for this process to go smoothly, particularly if your employees are stakeholders. Getting everyone on the same page before an equity dilution can help minimize potential internal dissension.

Securities laws and regulations governing new stock issuance prevent majority owners from making arbitrary decisions that affect common shareholders. These rules are subject to change, so it’s important to stay current. For instance, in January 2024, the SEC adopted new rules for IPO and SPAC transactions, expanding on disclosures and legal liability.

Stock dilution is not meant to be punitive. It's most often done to raise capital that can be used to grow and scale a business. Companies that go public may offer new shares of stock on the open market that could temporarily dilute existing share prices, but the objective is typically to increase value over time. That goal should be disclosed at the outset.

Equity dilution: pros and cons for startups

Most investors dislike seeing their share values decrease, but dilution is typically done to increase the company's overall value. That doesn't usually happen overnight, though there are instances where IPOs will garner immediate returns. That's one of the pros of equity dilution. There are also a few cons to be aware of:

Pros of equity dilution

• ‍Funding for business growth: Trading new equity for investor funding will dilute existing shares. This should only be done if a solid business plan is in place for using those funds. It should include pro forma financial statements that show how new financing will affect the balance sheet and cash flow report. The board of directors should approve the plan before voting on any action that could cause dilution.  ‍
• Higher potential dividends: Stock dilution typically lowers share prices in the near future, but growth fueled by equity investment should bring them back up. If the board votes to pay dividends, the value of those dividends may increase if the stock price rises. This should be explained at the shareholder or board meeting where dilution is introduced to the shareholders.‍
• Long-term growth: If the right plan is in place, short-term losses may lead to long-term gains. This can be a strong argument for equity dilution. There may be some resistance to it, though many businesses successfully navigate the process. Using equity to raise funds or as security for a business loan can indicate business development. With proper planning, dilution's challenges may be temporary.‍
• Employee retirement benefits: Larger corporations typically offer stock options or equity matches to employee retirement contributions. When share values are diluted, employees exercising their options have a bigger upside. Retirement portfolios may benefit if share values increase again, and that growth could be significant if they're able to reinvest their dividends.

Cons of equity dilution

• ‍Reduced share values: There are few guarantees in the business world. If the business plan is solid, the reduced share values caused by equity dilution may be temporary, but market conditions can sometimes derail your efforts. Shareholders should be aware of this reality. There are times when the best-laid plans just don't work. This is one of the drawbacks of equity dilution.‍
• Lower dividend payments: The board votes on dividend payments. They’re not automatic. When your goals are not being met, they may decide to lower dividend payments or not pay them at all. Dividends that are already fixed will be lower because share prices are lower. Your current shareholders and new investors will both see lower returns in this scenario.  ‍
• Sequence risk: Companies that match retirement contributions with company stock could subject their employees to sequence risk if share values don’t bounce back after dilution. The term is typically used to describe retiring in a down market. Lower share values reduce the overall retirement portfolio value, meaning retirees will have less to work with.   ‍
• Hostile takeovers: Lower stock prices make it easier for corporate raiders to take over a business. This generally happens when equity dilution lowers the ownership percentage of majority shareholders. It's rare in a private company. Many publicly traded firms aim to maintain at least 51% of the common stock as a protective measure. We'll cover more on that below.

Diluted ownership and valuation

Businesses that issue common stock in exchange for funding give new investors voting power. That’s why preferred stock is typically awarded in equity funding arrangements. It doesn’t dilute at the same rate as common stock or come with voting rights. Understanding how this works before doing your next funding round is important. 

Diluted ownership can be dangerous, particularly for startups and small businesses. Giving away too much common stock could change the balance of power at a company, particularly if several investors decide to partner with each other. Founders can avoid this by holding at least 51% of the common stock. Add that to your equity financing calculations.  

The valuation of your company sets the stock price. If you own 510 of 1000 shares in a company valued at $1 million, your equity stake is worth $510,000. Issuing additional shares in a secondary offering could reduce your ownership stake to under 51%. That could put you at risk of losing control of your business. It happens more often than you might think.

Equity dilution vs. debt financing: which is better for your startup?

While many business owners assume the cost of debt is higher than the cost of equity, the relationship is more complex. A company pays interest on debt but loses returns when it gives away equity. The risk factor is higher with equity, so the returns are potentially much larger. Awarding shares to equity investors means they receive those returns, not the company or employees.

A hybrid model of this is offering equity in exchange for debt funding. Lenders will sometimes agree to lend a business money and accept future equity as repayment. This may reduce the short-term liability for interest payments but could cost the company significant returns if share prices go up before the notes are executed. Consider that carefully before choosing this option.

Another financial variable is that interest payments are usually tax-deductible, lowering the cost of debt even further. Unfortunately, this may be challenging for startups that don’t have the necessary years of financial data to get approved for debt financing. That’s why you’ll often see entrepreneurs financing with equity when the company is still in its infancy. 

But be careful. Too much equity dilution may affect your ability to get additional equity or debt financing. Keep that in mind if you plan to do several fundraising rounds. Venture funds may be less likely to engage if your stock is significantly diluted. If they do, they might primarily be interested in buyout opportunities. Limit dilution so that it doesn't happen. 

Wrap up

Equity dilution is an option if you’re a founder trying to raise money for your company. Debt financing with business loans or lines of credit may not be possible when you’re in the early stages, so many founders turn to equity funding. Inform your shareholders if you choose this option because the value of their shares will decrease when you issue new shares.

If you're looking for alternative, non-dilutive options to fund your startup's growth, consider Rho's Corporate Cards.

With them, you can make the purchases you need to keep your business operations running smoothly without diluting your business, all while enjoying 1.25% cashback. Combined with Rho's expense management platform, you can make more strategic spending decisions and gain the insights you need to take control of your budget.

Want to learn more? Schedule time with a Rho finance expert.

Kevin Flynn is a guest contributor. The views expressed are theirs and do not necessarily reflect the views of Rho.

Rho is a fintech company, not a bank. Checking and card services provided by Webster Bank, N.A., member FDIC; savings account services provided by American Deposit Management, LLC, and its partner banks.

Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.