Equity Dilution: The What, Why and How of It
Audit giant KPMG’s Venture Pulse Report said that so far in 2021, global venture capital has reached an all-time high of $157.1 billion. The United States saw the highest number of unicorns, or companies valued over a billion dollars, as of Q2, 2021.
An increase in the availability of funds for startups has given them wings to scale new heights. Before blindly going in for more and more rounds, in the hopes that it will only have a positive impact, entrepreneurs need to understand all the facets of fundraising. While it is undoubtedly an important activity to keep the gears of a company turning, it comes with a flip side, which is equity dilution.
What Is Equity Dilution?
Equity dilution is the reduction of the owner’s stake in their company. It happens when a company issues fresh shares to other parties. In the context of startups, the most popular way this happens is when companies issue their shares in exchange for funding taken from investors (angels, VCs, PE, strategic investors). Let us understand how this happens through an illustration.
A new company, X Ltd, 1000 issued and fully paid-up shares, wholly owned by the proprietor. It issues 200 shares to an angel investor in exchange for funds to expand the company’s operations. The equity dilution is shown below:
Why Is Equity Dilution Important?
While funding is a requisite for most startups, the impact on the ownership must also be considered before going in for fundraising. This is because of the two key reasons discussed below
1. Earnings Per Share
The Earnings Per Share or EPS may reduce, which will affect the market value of the firm. Let us continue with the illustration above to show the impact of equity dilution.
In this example, the EPS is diluted by $2.5 due to the fresh issue of shares. Companies must calculate the Diluted EPS in order to capture the effect of potential equity dilution.
2. Voting Rights
Equity dilution may also mean dilution in voting rights, which can impact key managerial decisions that can act as positive or negative turning points.
How Can You Reduce Equity Dilution?
In order to receive something, you must be ready to give something up. This is true for startups too. It is seldom possible for an entrepreneur to have a 100% stake in their organization and also raise funds for the business to take off. If the stake is not diluted, the business may fail due to a lack of funds. If the stake is overly diluted, the proprietor might suffer. However, it is possible and necessary to have a tab on equity dilution. It can be reduced or at least kept under desirable levels in the following two ways.
Strong Policy Formulation
An entrepreneur must strike a balance between fundraising and diluting ownership. Every entrepreneur must ask this question to themselves and come up with an answer, at least before going for the second stage of funding: What is the maximum percentage of ownership that I am ready to exchange for funds?
Another way of looking at it is ‘What is the minimum percentage that I wish to own in the business, till the very end?’ Once the entrepreneur has internal clarity on the percentage of ownership that they are ready to give up, it will serve as a guiding principle in funding decisions and discussions.
Once this question is answered, the entrepreneur can, with the help of finance professionals, carefully construct a tentative timeline for different rounds of funding. Extensive discussions might be required within and with potential investors to finalize the plan.
The entrepreneur might have to revisit the percentage initially set, to make room for the practicalities of funding. By formulating strong policies, the entrepreneur can ensure that the company has adequate funds to grow while holding on to the desired level of ownership.
A company also has to decide the percentage allocation to different types of funding. If it opts for non-priced funding routes such as convertible notes or SAFE (Simple Agreement for Future Equity) notes, the impact of these on equity ownership has to be factored in while creating the policy. SAFEs are very young financial products that were first created in 2013 by Y Combinator. As the name suggests, a SAFE gives a buyer or an investor the option to purchase a company’s shares at a later round of fundraising. SAFE notes are free of interest and are more attractive to startups than conventional convertible notes. These alternatives may prove to be more beneficial to a startup than fundraising rounds.
While ESOPs have the advantage of compensating employees well without adding pressure to the company’s liquidity, they also cause equity dilution. When companies issue ESOPs or add shares to an ESOP pool, the total number of shares increases, which dilutes the equity in the same way as explained previously.
One way to counter this disadvantage posed by ESOPs is to issue phantom stocks in place of them. Phantom stocks do not involve the actual issue of shares, yet offer equity-linked compensation to motivate employees to work towards augmenting the value of the company.
Are phantom stocks perfect for you? Click here to find out.
An important tool to ensure that your startup’s equity is not getting diluted beyond set limits is by tracking the evolution of equity right from the beginning. All events must be recorded and their impact must be visible. At any given point in time, the Statement of Changes in Equity must be up-to-date. Having a capitalization table or cap table helps capture and present this information in an easy-to-understand format that can help in having a grip on equity dilution.
The cap table can be more useful for decision-making by making it futuristic. This can be done by making educated presumptions about where the company is headed and what are equity-related decisions the management will have to make to support the company’s growth. Once these potential events are identified, the impact of these events on the equity can be projected if they were to occur. This process is called scenario modeling. It is essentially a forecast of the Equity Statement, emphasizing the ownership percentages under different potential scenarios. For example, it would show by what percentage your stake in the company would dilute if you decide to go in for another round of funding within the next year. A visual representation of the impact of a potential equity event is extremely helpful to an entrepreneur to decide which course of action to pursue.
trica equity’s cap table contains these features and more. Click here to see the full list of features of our cap table.
A startup’s biggest concern is fundraising. Without the necessary funds, it is impossible to operate the business and generate revenue. While gaining access to funds is undoubtedly a top priority, startups must ensure that they do not overindulge in fundraising, to the point that it materially impacts the ownership in a way that the proprietors are not comfortable with. Equity dilution must not be forgotten in the race to move ahead.
Are you concerned about equity dilution impacting your ownership in your startup?
trica equity’s cap table solutions contain all the features to enable you to balance your company’s growth and equity dilution. Get in touch with us today to know more or book a demo!