Are you wondering what equity dilution is? Do you want to know how it happens and how to avoid it? Well, this blog will guide you through each of these topics and more. We will take you through what equity dilution is, the reasons and consequences of dilution, and some ways to avoid it.
When a company needs to raise more share capital, they issue more shares to investors. Due to an increase in new shares, the value or the percentage of existing shares decreases. Equity dilution is the decrease or cut down in stock holdings of existing shareholders due to the addition of new investors. This happens when the number of shares goes up but the profit earned remains the same, due to which earnings per common share go down.
For example, company ABC has two founders. Each founder holds a 50% share in the company. The company wants to increase equipment, for which they need more capital. To raise capital, they decided to issue new shares. The value of the new share will be 20%. When a new investor buys the share, the value of existing shares will decrease to 40% each. This decrease in the share’s value from 50% to 40% due to adding a new share of 20% is equity dilution.
Equity dilutions have both positive and negative consequences. Therefore, before issuing more shares, a company should estimate positive and negative consequences.
Don’t raise more money than you need: Raising additional money frequently feels like a sign of achievement and the secret to growth, especially at the company’s early stage. However, it’s crucial to consider how much cash you will need to invest in your company at different stages of its development. So do your best to estimate how much money you will need to raise to advance your firm before going out to raise money.
Keep an eye on the capitalization table: A capitalization table is a table that displays the total number of shares outstanding along with each shareholder’s ownership stake in a company. It is a very helpful tool for controlling your ownership of a developing business. A capitalization table can be used to simulate how different funding options will affect the ownership stake of current shareholders and profit per share.
Don’t create a bigger pool of employees: If you recruit more than you need, your ownership will dilute more. To avoid this, develop a recruiting strategy to determine your ideal pool size. This strategy could also be useful in negotiations with investors.
To summarize the lesson, equity dilution occurs when the value of your ownership share decreases. This can happen when your company raises funds, sells new shares, or issues options to new employees. It may be necessary if you need to dilute your ownership to raise money. Still, you will want to slowly and carefully apply a dilution to avoid real damage to your company’s or your personal equity.