Revisiting Dilution

Time flies when you’re having fun. In November & December 2018, I wrote a series of posts about ownership dilution in the context of startup fundraising – it seems like it was yesterday – but apparently it was more than two years ago! If you’re interested in checking out those posts, they’re available here and here.

In the intervening time, dilution has continued to regularly come up as a point of confusion among new founders and entrepreneurs. In addition to the posts linked above, here are some updated things to keep in mind with regard to dilution:

  1. Dilution is a math problem. I know! I became a lawyer because math was never my strong suit – but whether you’re an entrepreneur or, just a guy that advises new companies like me (startup adjacent), dilution (as a concept) is something that everyone needs to be comfortable with – especially if the company plans to seek outside financing.
  2. “Dilution” occurs when a company issues new shares that result in a decrease in existing stockholders’ ownership percentage of that company. (Check out the posts above for a more in depth explanation of the basics.)
  3. “I’ll just give the new investor part of my [ownership] share so I don’t dilute anyone.” Nope, sorry, it almost always doesn’t work like that. If a shareholder gives (or sells) his\her ownership in the company to another third-party to “avoid” the dilution math problem (i.e. issuing new shares) the selling shareholder experiences a tax event – if the company has appreciated in value (we hope!) the seller will pay (at best) capital gains tax (or worst, income tax) on the appreciated value. Most of the time, this situation should be avoided.
  4. Equity and share value will matter – sooner than you think. A lot of Founders believe they can give capital ownership in the Company away “for free” without any adverse effects on themselves or the other shareholders. While that might be true at the outset of the Company (because its, defensibly, worth $0.00) – the Company will start to appreciate in value very quickly. When that happens, shares given away “for free” result in taxable income to the receiving shareholder and will dilute (diminish) the value of the other shareholders’ ownership. This can certainly become a tax issue, but also a political issue internally at the Company – and fast.
  5. tl;dr – get your cap table in line now, learn about dilution, and prepare to understand and explain the concept to your other team members. If you need an Excel spreadsheet to play with the numbers – I have one and am more than willing to share, just ask.

This post brought to you by the amazing Boston album “Third Stage.” Thanks for reading.

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