For a startup, stock dilution is an ownership impact caused by the issue of additional shares of common stock. When the startup issues more common stock, by definition a stockholder then owns a smaller percentage of the total number of shares. This is stock dilution. It impacts both shares and options.
From a Silicon Valley perspective, all startup shareholders need to understand that they will be diluted. The well-informed CEO makes sure that anyone receiving equity understands this before they receive any equity. Unless the startup CEO wants to give him/herself a headache and lose the respect of others, he/she should not allow any shareholder to receive contractual protection against dilution.
Some investors such as some European real estate developers expect to receive anti-dilution protective covenants in their term sheets. Any Hitech startup that gives this protection needs to understand that it will be difficult to raise funds from others without also giving the new investors dilution protection. If the startup needs more than two or three rounds of investment (as almost all do), this quickly becomes a “MESS”. Such a Hitech startup is very unlikely to make it on to any professional investor’s shortlist of investment opportunities.
This issue of new shares might be caused by:
A tranche of investment
An initial public offering (IPO)
Or less likely the conversion of convertible bonds or warrants into stock
The dilution can result in
Changes in ownership percentage
Changes in voting control (see Control Dilution below)
Or less likely in importance, from a startup perspective; changes in income per share or changes in the worth of individual stocks
“Control dilution” refers to the potential loss of voting control or influence due to stock dilution.
From a Silicon Valley perspective, all startup shareholders need to understand that they will experience stock dilution.
- If a startup can always issue new shares, what value is there to stocks/options?
- 8 Ways To Maximize The Value Of Your Startup Stock