Dilution: why founders own less after every round

What is dilution?

Dilution happens when a company creates new shares and sells them, so each existing share represents a smaller percentage of the company. If you own 10 shares out of 100, you own 10 percent. If the company issues 100 new shares to investors, you still own 10 shares, but now out of 200, so you own 5 percent.

Dilution is not the same as losing value. If the new money helps the company become worth much more, a smaller percentage can be worth more in rupees than a bigger percentage of a small company. The point of a funding round is to make the pie larger, even if your slice is thinner.

How do you calculate dilution?

The simple way is to use the investor's stake. If a new investor receives 20 percent of the company after a round, existing owners are left with 80 percent of what they had before. So a founder with 60 percent keeps 60 x 0.80 = 48 percent.

Another way is to compare share counts. A company with 1,000,000 shares issues 250,000 new shares. The total is now 1,250,000 shares, so the new investor holds 20 percent, and anyone with the original shares holds 80 percent of their earlier percentage. Both methods give the same answer, because the percentage sold equals new shares divided by the total after the round.

Why does dilution happen at every stage?

Startups need money before they make money, so they sell shares to fund growth. Each priced round, from seed to Series A, B and later, sells a slice of the company. A typical early round sells roughly 10 to 25 percent, but this varies a lot. After several rounds, founders of many venture-backed companies hold well below half the shares.

There are other sources of dilution too. A pool of shares set aside for employee stock options (ESOPs) dilutes existing holders when it is created or topped up. Convertible notes and iSAFE notes turn into shares later and add dilution when they convert. Even giving shares to an advisor or a new co-founder dilutes the others.

• New priced rounds: seed, Series A, Series B and later.
• Employee stock option pools, created and refreshed.
• Convertible notes and iSAFE notes converting into shares.
• Shares issued to advisors, new co-founders or in acquisitions.

What is the effect over several rounds?

Dilution compounds, meaning each round reduces the stake that is left after the one before. A founder who starts with 100 percent might sell 15 percent at seed, 20 percent at Series A and 15 percent at Series B. The founder is left with 100 x 0.85 x 0.80 x 0.85, which is about 58 percent, before counting the employee pool.

Add an option pool of 10 percent at Series A and a further top-up later, and the founder may hold roughly 50 percent. With two co-founders sharing equity, each may hold a quarter or less. This is normal and not a sign of a bad deal, but founders who want to keep control should plan for it.

Can dilution be reduced or avoided?

Founders cannot avoid it if they raise equity, but they can limit it. They can raise only what they need, since selling less now leaves more for later. They can negotiate a higher valuation, which means fewer shares for the same money. They can keep the employee pool no larger than the hiring plan needs. They can also use non-equity funding, such as venture debt or revenue-based financing, for part of their needs.

Another approach is to grow with little outside money, which is called bootstrapping. That keeps ownership high but may mean slower growth. The right balance depends on the market. In winner-takes-most markets, raising more and diluting more can be the better route to a larger result.

What is anti-dilution protection?

Investors can protect themselves against a specific kind of dilution: a later round at a lower price. Anti-dilution clauses adjust the investor's conversion price, so they receive extra shares when the company sells shares cheaper than before. The two common types are full ratchet, which resets the price all the way down, and weighted average, which adjusts it by a smaller amount based on how many new shares are sold.

These clauses protect the investor but pass more dilution to founders and employees, so they matter most in a down round. Founders should understand which type their term sheet includes.

When is dilution worth it?

Dilution is worth it when the money creates more value than the share of the company it costs. A founder who sells 20 percent for money that doubles the company's value is better off than before. A founder who sells 20 percent and the company stays the same is worse off, because the same business is now owned in smaller pieces.

One useful test is to ask what the money will buy and what that will do to the value of the company. If the plan is to hire engineers and launch a product that opens a new market, the link is clear. If the money only covers losses with no change in the business, dilution is a cost without a gain.

How do founders and investors think about it differently?

Founders watch their percentage, because it decides control and, eventually, their payout. Investors watch the percentage they hold at exit, so they focus on how many future rounds will dilute them. This is why some investors insist on pro-rata rights, which let them buy more shares in later rounds to keep their percentage.

Both sides accept dilution as the price of growth. The difficult cases are the ones where it comes with weak terms or where there is too much of it too early, which can leave founders with little motivation to stay. Investors sometimes top up founder equity with new options in a later round to fix this.

For readers, one more point helps when reading funding news: a headline that says an investor bought a certain percentage tells you how much the existing owners were diluted in that round. If a report says a fund took 20 percent, everyone who owned the company before now owns four fifths of their earlier share. That is a quick way to estimate what founders gave up, without needing to see the full cap table. Remember that employee pools and notes may add further dilution that the headline does not show.

How does dilution affect employees?

Employees with stock options feel dilution too. When the company raises more money, the percentage their options represent falls, although the value per share may rise. Companies often top up the pool to keep options meaningful for new hires.

In a down round, the shares are worth less per unit, and dilution plus a lower price can make options feel worthless. This is one reason founders try to avoid a down round and why they explain ESOP maths clearly to staff. This guide is general information, not financial advice.

Read next

• What is a cap table?
• Pre-money vs post-money valuation
• Anti-dilution protection: full ratchet vs weighted average
• What is a down round?
• How startup valuation works