dilution
Dilution refers to the decrease in ownership percentage for existing owners that occurs whenever a company grants new equity. This happens most commonly when the company raises money or grants new stock to an investor or employee. When the company adds more stock to give to the investor or employee, the ownership positions of the previous shareholders are decreased or "dliuted."
How the Math Works
If a company is equally and wholly-owned by two founders Sally and Sam, Sally and Sam would each own 50% of the company. Let's assume that the company has 10,000 shares in total (or membership units if it is an LLC). Sally owns 5,000 shares and Sam owns 5,000 shares. Now, let's assume that they raise $5,000 from Sally's rich uncle, Uncle Joe. Uncle Joe says he will give them the money but he wants equity in return. They agree to give him a 25% stake in the company for his $5,000 investment. This automatically implies that the company is worth $20,000 since Uncle Joe just bought 25% of the company for $5,000. $5,000 divided by 25% equals $20,000.
Companies generally raise money by issuing new shares to new investors (as opposed to selling their shares). They do this because it is much simpler legally for the company to issue new shares than it is for the company to determine the appropriate amounts each previous shareholder would need to share to a new investor and negotiate legal agreements for each seller. So the question is how many shares should the company issue to Uncle Joe. He will need to have 25% of the shares as well to get a 25% stake. So, we simply divide the existing number of shares (before the investment) by 1 minus the percentage that Joe will ultimately own. 1 minus Joe's percentage equals 75%. This represents the percentage that previous shareholders will own of the company after Joe invests. The total number of shares before Joe's investment equalled 10,000. 10,000 divided by 75% equals 13,333.33 shares. This is the total number of shares after Joe's investment. Since we know that previous shareholders didn't lose or sell any of their shares, this means that Joe receives, 3,333.33 shares. Joe's stake in the company is thus 3,333.33 (his number of shares) divided by 13,333.33 (the total number of company shares) which equals 25%.
Because ownership percentage pie (the sum of the ownership stakes of all shareholders) must always equal 100% and we just added a new piece of the pie that equals 25%, we know mathematically, that Sam and Sally's ownership percentage will decrease. We can find out exactly what they decrease to by dividing their ownership stake 5,000 shares each by the total number of company shares, 13,333.33. The result is that Sam and Sally will each own 37.5% of the company after raising money from Uncle Joe.
This decrease in ownership stake from 50% to 37.5% is called dilution.
Dilution For Previous Shareholders who Receive New Shares
Dilution will occur even when a shareholder is both a previous shareholder and a new investor. In other words, even if Startup Capital owns 30% of the Startup Technologies, Inc. and decides to invest an additional sum in exchange for more shares of the company, it will partially dilute its previous ownership stake by getting new shares. The net effect of this transaction will increase the ownership stake of Startup Capital but it will also slightly dilute its previous ownership stake.
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