What is dilution?

Key takeaways

• Dilution is the decrease in shareholders' equity positions that occurs when new shares are issued or created.

• Sometimes companies offer dilution protection to preferred shareholders so that their ownership percentage won’t go down.

• When a firm raises additional funding, dilution can occur, which often puts existing shareholders at a disadvantage.

What is dilution?

There are many events that can affect the value of an investment. When a company issues new shares, the percentage of the company that each investor owns is “diluted,” or decreased. 

Dilution may sound like a bad thing, but that’s not always the case. It all depends on the valuation of the company at the time of issuance. The valuation can either go up, down, or remain the same.

Dilution in uprounds

• In an “upround,” the valuation increases, and the shares become worth more. During this time, dilution causes the investor to own a smaller percentage of the overall company.

Dilution in downrounds

• In a “downround,” the valuation decreases, and the shares become less valuable. In this case, dilution will leave the investor with owning less of the company (not something investors want to see). 

There are also times when the valuation will stay the same. In this case, the shares won’t change in value, but as a result the investor owns a smaller percentage of the company. 

How dilution works

It’s like watering down a drink.

 Let’s say you’re making instant iced tea and the recipe calls for one part tea mix to four parts water. If you add six parts water, the iced tea gets diluted, and the tea won’t be as sweet. 

The same thing happens when a company adds more shares to the cap table—the value of each share is diluted (your ownership gets smaller) and the amount of outstanding shares gets bigger.

When dilution occurs

There are a few ways that dilution can occur. 

• A corporation issues new stock to raise money for growth and expansion

• A company goes through an additional round of financing and issues new shares

  • Crowdfunding (what many companies do on Republic) is an example of this

  • Raising from VC or other private funders is another example of this

Sometimes companies offer dilution protection to preferred shareholders so that their ownership percentage won’t go down. 

How dilution affects investors

Valuation and dilution are connected. When a company’s valuation increases, the individual share’s value that a shareholder owns increases. If a shareholder’s percentage in the company has decreased due to dilution, the total value on paper may still be the same or increase in value because the value of the company overall has increased. 

For example, if an electric car company is valued at $5M and you own 10% of the company, your current holdings are worth $500,000. If the company then raises additional capital and issues new shares, the stock is therefore diluted to 5%. 

However, the company’s value may have increased to $10M. The decline in holding percentage from 10% to 5% may seem like a loss, but in reality that 5% is still worth $500,000 because of the increase in the company’s overall value. 

This is just one example of what can happen with your investment. Each company has their own fundraising journey and you have the opportunity to invest in a company you believe in.  

This is the magic and the risk of being an early investor. There’s always potential for upside and the risk of losing it all. 

It is important that you read the terms of your investment instrument carefully to understand whether or not it contains dilution protection. Dilution, particularly in early stage financing, is exceedingly common. By itself, dilution isn’t necessarily a bad thing since you can still see a significant return on your investment even when dilution occurs.