Dilution

What it means

Dilution is the reduction in an existing shareholder’s percentage stake that occurs when a company admits a new shareholder or issues new shares. The number and value of the original owner’s shares do not change, but they own a smaller part of a larger whole.

Dilution most often occurs in a funding round, when an investor pays for a new stake; in a share capital increase with a new shareholder; when a convertible loan converts into equity; or when an employee share option plan is exercised.

Dilution need not be bad for a shareholder. If the investment increases the company’s value, a smaller stake may be worth more than the larger one was. The pre-money valuation at which the investor comes in is what decides.

How it works in practice

With every round or change in ownership we update the cap table with the client and calculate how each shareholder’s stake will change. Founders can see in advance what percentage they will keep after the round and what effect further planned rounds will have.

In the term sheet and investment agreement we check the anti-dilution provisions. Investors negotiate them in case the company later raises money at a lower valuation. Different types of protection affect founders very differently.

In a limited company, dilution is reflected in the articles and in the commercial register entry. Existing shareholders usually have a pre-emptive right to subscribe in a capital increase, and if they do not want to use it they must waive it, or the process is held up.

What to watch out for

Over several rounds, dilution compounds faster than founders expect. A stake that looks safe after the first round can fall after the third below the threshold that gave the founders control over key decisions.

For minority shareholders, dilution may push their stake below statutory thresholds that matter for their rights, such as the right to call a general meeting. Before a round we therefore go through with the client which rights attach to which stake.