Definition
Dilution occurs when a company's total number of shares or other ownership interests increases, causing an existing shareholder to represent a smaller percentage of the company.
For example, if a founder owns 1,000 of a company's 1,000 shares, they own 100%. If the company issues 250 new shares to an investor, there are now 1,250 shares. The founder still owns 1,000 shares, but their ownership has fallen to:
1,000 ÷ 1,250 = 80%
The founder has therefore been diluted from 100% to 80%.
Dilution is a change in percentage ownership, not necessarily a loss in the absolute number of shares held.
How does dilution happen?
Dilution can occur when a company:
Raises equity financing
Issues employee stock options
Creates or expands an employee option pool
Converts convertible securities into shares
Issues shares for acquisitions
Grants other equity-linked securities that become shares
The precise effect depends on the company's capital structure and the terms of the transaction.
Dilution during a funding round
Suppose a startup has:
1,000,000 existing shares
An investor purchases 250,000 newly issued shares
After the investment:
Total shares = 1,250,000
The investor owns:
250,000 ÷ 1,250,000 = 20%
The existing shareholders collectively own:
1,000,000 ÷ 1,250,000 = 80%
The existing shareholders have therefore experienced 20 percentage points of dilution.
Dilution does not necessarily mean losing value
This distinction is important.
Suppose a founder owns:
100% of a company valued at $1 million
Their ownership is worth approximately $1 million under the simplified assumption.
The founder then sells 20% to an investor for $1 million.
After the financing, the founder owns:
80% of a company valued at $5 million
Their ownership would now be worth approximately:
80% × $5 million = $4 million
The founder owns a smaller percentage but a substantially more valuable interest.
Dilution should therefore be considered alongside the valuation and capital raised, not viewed solely as a percentage loss.
Dilution and valuation
The amount of dilution in a financing depends partly on the relationship between the investment and the company's valuation.
For example:
Pre-money valuation: $8 million
New investment: $2 million
Simplified:
Post-money valuation = $8M + $2M = $10M
The new investor's ownership is:
$2M ÷ $10M = 20%
Existing shareholders collectively retain 80%.
Dilution from employee option pools
Employee equity can also affect founder ownership.
Suppose founders initially own 100% of a company.
The company creates an employee option pool representing 10% of the company.
The founders' ownership becomes approximately 90%, assuming the pool is created through new shares and no other changes.
Option pools can have important effects during fundraising because investors and founders may negotiate whether the pool is created or increased before or after the investment.
Dilution from convertible instruments
Convertible notes and other convertible securities can convert into equity during a future financing.
When conversion occurs, new shares may be issued to the holders of those instruments.
Existing shareholders can consequently experience dilution.
The amount of dilution depends on factors such as:
Conversion price
Valuation cap
Discount
Accrued interest
Financing terms
Existing capital structure
This is one reason founders should model future ownership rather than looking only at their current cap table.
Dilution and multiple funding rounds
Dilution can occur repeatedly.
For example:
Before Seed:
Founder: 100%
After Seed:
Founder: 80%
Seed investor: 20%
After Series A:
Founder: 60%
Seed investor: 15%
Series A investor: 25%
The founder has experienced dilution in both financing rounds.
The seed investor has also been diluted in the Series A because new shares were issued.
Dilution vs. selling shares
There is an important distinction between primary and secondary transactions.
Primary financing
The company issues new shares to an investor.
The company's total share count increases, potentially diluting existing shareholders.
Secondary transaction
An existing shareholder sells existing shares to another investor.
The company's total share count does not necessarily increase, so existing shareholders who are not selling do not experience the same type of dilution.
The seller's ownership decreases because they sold shares, while the buyer acquires those existing shares.
Dilution and control
Dilution can affect more than economic ownership.
If a founder's voting ownership falls sufficiently, their ability to control shareholder decisions can change.
However, percentage ownership does not always equal voting control because different share classes can carry different voting rights.
Therefore, founders should consider both:
Economic dilution
Voting dilution
Anti-dilution protection
Some preferred investors receive anti-dilution protection under specified circumstances.
These provisions can adjust the conversion terms of preferred securities when a company subsequently raises capital at a lower valuation or price per share.
The precise mechanism depends on the financing documents.
Anti-dilution protection can itself affect how dilution is distributed among shareholders.
Pro rata rights
Some investors negotiate pro rata rights, allowing them to participate in future financing rounds to maintain their ownership percentage.
For example, an investor owning 10% may have the right to purchase enough shares in a subsequent financing to continue owning approximately 10%.
Exercising that right requires the investor to contribute additional capital.
Dilution vs. loss
Dilution does not mean that a shareholder has lost shares.
In the basic example:
Before:
Founder owns 1,000 shares out of 1,000 = 100%
After:
Founder owns 1,000 shares out of 1,250 = 80%
The founder still owns 1,000 shares.
What changed is the founder's percentage of the total company.
Example
A startup has 2 million shares.
Founder A owns 1 million.
Founder B owns 1 million.
Each therefore owns 50%.
The company raises a new financing round by issuing 1 million shares to an investor.
After the financing:
Founder A: 1M / 3M = 33.3%
Founder B: 1M / 3M = 33.3%
Investor: 1M / 3M = 33.3%
Both founders have been diluted from 50% to approximately 33.3%.
The company, however, has received new capital that may enable it to grow.
Common misconception
Dilution is always bad for founders.
Not necessarily.
Dilution reduces a founder's percentage ownership, but the financing that causes dilution can increase the company's value substantially.
The relevant question is not simply:
"How much ownership did I give up?"
It is also:
"What did the company receive in exchange, and how does that affect the value of the ownership that remains?"
A smaller percentage of a significantly more valuable company can be economically better than a larger percentage of a company with insufficient capital to grow.
