Few events strike as much fear in the hearts of start-up investors as dilution. Many go through great lengths to include anti-dilution clauses that protect the specific percent share of a company that they signed up for. If they buy or earn 10% of a company then they want to keep 10% of the company, often with little thought to the underlying value of the company. Dilution, however, isn’t necessarily a bad thing. In fact, dilution can be a great sign that your company is growing and doing the right things.
Dilution is a natural adjustment in ownership that occurs when the company distributes more shares to those who deserve it. So, if I own 50 out of 100 shares I own 50% of the company. If it’s a start-up company my 50% is probably worth nothing. However, if the company sells half the company for $1,000,000 and issues another 100 shares my ownership dilutes to 25% instead of 50%. However, the underlying value of my ownership went from being worthless to being worth $250,000. In this case, dilution is a good thing. I never would have built value in the company unless I was willing to be diluted.
Our fear of dilution will often have a negative impact on our ability to succeed. It will prevent us from bringing on valuable partners or employees that might deserve equity in our company. Our inability to realize that a small percent of something is infinitely better than a large percent of nothing holds us back.
The reason people fear dilution is because we don’t want to be taken advantage of by other participants in the company. If I invest in a company and receive 10% of 100 shares (10 shares) what’s to prevent the owners from simply granting more shares to themselves and diluting my shares with no gain in value? In this case other people will benefit at my expense. However, the reverse is also true. If the company has to issue me more stock whenever they issue stock to someone else I am essentially getting more stock for doing nothing. So, I am benefiting at the expense of others. Both scenarios are problematic. However, most of us would rather have the problem of getting more than we deserve.
In an ideal world every participant in the company would get exactly what they deserve—no more and no less. If we are all getting exactly what we deserve then there is no reason to worry about dilution. You can always rest assured that no matter what your share, it is always fair relative to others. The only way to achieve this, however, is through the use of a dynamic equity split program. Dynamic splits are not widely used today because they are not widely understood. Most companies use a fixed or static-split which is very difficult to keep fair. We try to compensate by using vesting programs, options programs and numerous protection clauses like anti-dilution. Equity negotiations are among the most painful and destructive events at a start-up. They pit people against each other who should be working together. It’s every man for himself.
However, in a dynamic equity model everyone is guaranteed to get what they deserve. In a dynamic model a relative value is put on the various contributions people make to the start-up. Contributions can include time, money, ideas, relationships, equipment, faculties and other necessities that help a business grow. You calculate ownership by dividing what you contributed by the total of all the contributions made by everyone on the team. Therefore, your percent ownership is always exactly what you should have. Dynamic models change during the early days of a start-up so dilution is a natural part of the process.
Dilution, under the right circumstances, is a positive sign that everyone in a start-up company is being treated fairly by everyone else. Under the wrong circumstances dilution is a sign of greed, mistrust and ego.
Originally appeared on Under30CEO.com
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Found this helpful too http://brandalyzer.wordpress.com/2014/01/24/how-start-up-equity-dilution-works/