How Dilution Impacts Private Company Investments

Congrats! A company you’ve invested in just announced a new funding round. But is this always good news? It depends on how dilution impacts your stock ownership. Dilution is the reduction in ownership percentage for existing shareholders following the issuance of new stock. Here we’ll cover what investors and shareholders in private companies should know about equity dilution.

In the private market, the effects of dilution are often seen as material changes to a company’s capitalization table, or cap table. The cap table displays the ownership structure of a company and outlines provisions relevant to the securities held by investors. 

Why Does Dilution Occur?

Dilution typically occurs when a company chooses to issue new stock. Companies do this for a variety of reasons including:

• Raising Capital: companies raise capital to drive growth or bring on new investors and strategic advisors with unique expertise. In an equity fundraise, companies often issue additional shares of private company stock. These rounds are typically denoted as different series of funding - Series A, B, C, etc. 
• Convertible Debt Financing: a company may choose to issue convertible debt, which gives lenders the option to convert debt into equity if the value of the equity exceeds the value of the debt. Convertible securities are an effective form of financing and an alternative to a standard equity raise.
• Employee Compensation: a company may issue additional stock in the form of employee stock options or restricted stock units (RSUs). Equity compensation can help attract new talent or increase employees’ stake in the success of the company, aligning incentives over the long term. 

Dilution's Impacts on Ownership Stakes 

To understand the impact of dilution, take for example fictional Company X, with the corresponding cap table below. The cap table shows that there are 5 million shares outstanding. These shares consist of Common Stock and Series A Preferred Stock. 

*For illustrative purposes only.

In this hypothetical scenario, as an investor in Company X, you own 100,000 shares of Series A Preferred Stock. This means you have a 2% stake in the company. This percentage stake is calculated by dividing the number of shares held by an investor by the total number of shares outstanding (100,000 divided by 5M).    

Now consider the company decides to authorize and issue 5M shares of Series B Preferred Stock in a new funding round. The total shares outstanding increases from 5M to 10M. As a Series A Preferred Stock investor, you maintain your 100,000 shares. As a result of dilution, your ownership stake is reduced from 2% to 1% (100,000 shares held divided by 10M shares outstanding). 

*For illustrative purposes only.

How to Value Diluted Shares

Is dilution bad? Not always. Dilution does not necessarily correspond to a decrease in the value of the shares you hold in a company. If a company authorizes and issues new shares at a higher price than the price at which you acquired shares, it is likely that the value of your holding has increased. This means that the post-money valuation is less than the pre-money valuation. That’s a win. This is typically the case when growing private companies raise new rounds of funding at higher valuations. However, if a company’s valuation decreases upon the issuance of new shares, it is possible that your shares have decreased in value.

Let’s look at an example of this with Company X. Say Company X was valued at $25M as of the Series A funding round, meaning the price per share in that round was $5 ($25M divided by 5M shares). After raising the Series B round, the company is valued at $100M. This valuation implies that the round price per share was $10 ($100M divided by 10M shares). While your ownership stake decreased from 2% to 1%, the value of the shares increased from $500,000 to $1M (the number of shares multiplied by the share price). Because of this funding round, your shares are now worth more.

Dilution + Liquidation 

Liquidity rank and liquidation preference are security provisions. They determine the order and amount that investors will be paid out in a liquidity event like a merger, acquisition or bankruptcy filing. Note that if a company goes public via an IPO, these provisions become less relevant. This is because preferred shares typically convert to common stock in an IPO, forgoing the liquidation ranks of each security. 

A company may detail liquidity rank and liquidation multiplier in its company filings as such: “In the event of any liquidation of the Company, the holders of [Security Name] shall be entitled to receive prior and in preference to [Security Name] a per share amount equal to [X] times the Original Issue Price.” 

Let’s take another look at our cap table before the issuance of Series B Preferred Stock, adding in liquidity rank and liquidation preference. In the table, Series A Preferred Stock has a higher liquidity rank than Common Stock. This means the company will pay preferred stockholders before they pay common stockholders. The liquidation preference indicates the liquidation multiplier, which is most commonly 1x.

With a 1x liquidation multiple, the investor has the right to their initial investment upon liquidation. If the multiplier was 2x, the liquidity preference would be two times the original issue price, multiplied by the number of shares outstanding. In other words, the investor would have the right to receive two times their initial investment before the company pays other investors. 

*For illustrative purposes only.

Now, let’s add Series B Preferred Stock back into the equation. In this example, the issuance of new shares prioritized distributions to Series B Preferred Stock holders before Series A Preferred Stock holders. However, distributions to Series A Preferred Stock holders still have priority over distributions to Common Stock holders. 

Given this setup, if Company X is acquired, $50M must be paid to Series B investors before Series A receives $22.5M - and this must happen before Common Stock gets any payout. Because of this, it is important to understand that dilution can affect not just ownership stake, but the rights investors have to liquidity. 

*For illustrative purposes only.

Voting Rights + Stock Dilution

Liquidation rights aren’t the only rights investors can have. Voting rights are another key provision. Each private company share comes with a certain number of votes. These votes can be used in meetings, for proposals, or to choose the Board of Directors.

Many companies issue additional voting rights to select shareholders to concentrate decision-making power. Voting rights are impacted by dilution when the issuance of new shares increases and thus the marginal impact of an existing shareholder’s vote decreases.

Anti-Dilution Provisions

As companies raise new funding rounds, security provisions like voting rights and liquidation preferences are often revisited. The price per share and liquidation preferences can be subject to negotiation with new investors. However, there are protective provisions that existing investors can implement to safeguard against dilution in these new rounds, like pro rata rights. 

Fast-growing companies that attract many investors may have more power over the rights of new shareholders. This could limit voting rights or liquidation preferences for these new investors. Meanwhile, companies that need money quickly and have less interest from investors may offer extra rights to attract investors.

Ratchet provisions are one way of protecting existing shareholders from dilution. They change the conversion price of a share class if there is a down round. A down round is when new shares are sold at a lower price than in earlier funding rounds. In other words, if the value of company shares decrease, shares previously bought at higher prices will be adjusted, effectively increasing the number of common stock shares they can be converted into. There are two main forms of ratchet provisions:

• Full-Ratchet Anti-Dilution adjusts the conversion price based on the price of the new shares issued. 
• Weighted Average Anti-Dilution adjusts the conversion price based on the average price of new shares issued. 

These mechanisms enable shareholders to convert to common stock at a lower price, mitigating the effects of dilution. 

What Investors Need to Know 

In private markets, dilution is an inherent factor impacting equity ownership. For investors, it's not a reason for alarm, but a crucial element for understanding the value of company shares. Understanding the company's capitalization table and the terms of new share issuances is important. This knowledge is key to equity research, helping investors turn a potential threat into a manageable risk.

Interested in understanding how share dilution can impact the cap table of a specific private company? Explore cap tables of private companies on EquityZen’s platform. Simply search for the company and navigate to the “Capitalization table” tab. EquityZen’s research team prepares capitalization tables for all Standard Deals using company filings to help investors make more informed decisions. Explore today.

Sample cap table displayed above