What is dilution?

Dilution: definition

Dilution occurs whena company issues new shares that result in a decrease in the percentage of ownership of existing shareholders in that company. As a founder, you may have to finance your growth by raising funds from investors. These investors will then have shares in your company's capital and you will have to deal with a new shareholder.

Share dilution can also occur when holders of stock options, such as employees of the company, or holders of other option securities exercise their options. As the number of shares outstanding increases, each existing shareholder owns a smaller, or diluted, percentage of the company, reducing the value of each share.

Companies sometimes issue new shares to secure a partnership, reward an employee or raise funds. In most cases, the new shares issued will be common shares, which give the shareholder voting rights. In cases where the company is seeking to raise equity without giving up voting rights, it may issue preferred stock, which is essentially a dividend-paying bond.

The difference between capital dilution and share transfer

Dilution is therefore the situation where the founders of the company see their percentage of ownership of the share capital of their company decrease following a fund raising for example. It differs, however, from the transfer of shares. In the case of the transfer of shares to a new shareholder, the founder's shares change hands.

In concrete terms, when a dilution occurs, the number of shares owned by the founder does not change but his percentage of ownership and his value decrease.

Let's take the example of the share capital of the company L'Oiseau which is composed of 100 shares held by the founder at 100%. He decides to raise funds and issues 20 new shares to a Business Angel.

Then the founder will only have: 100/(100 + 20) = 83.3% of the share capital of L'Oiseau.

Nevertheless the number of shares held remains 100.

When these new shares are issued, they are purchased at a price, technically "subscribed" by the new investors. The price of the share is broken down into two parts:

The nominal value of the shares: it is the price of each share fixed at the creation of the company. It is recommended to have a value as low as possible to manage your capital in the best way.
The share premium: this is the difference between the price per share and the nominal value of the shares.

Thus, when you raise funds, your share capital is increased only by the par value and not by the share price (share premium + par value)

Calculation of the dilution of the share capital

The dilution can be calculated as follows:

%det.post = (%det.pre x valuation + new founding contribution) / (valuation + capital increase)

With :

%det.post = % of founders' holding after the capital increase ;
%det.pre = % of founders' holding before the capital increase ;
Valuation = valuation of the company at the time of the capital increase;
New Founder's Contribution = Additional Founder's Amount if any
Capital increase = total amount

Example of a capital dilution calculation

Let's take the example of the company L'Oiseau. The founder owns 80% of the capital and his brother 20% following a financial contribution. The capital is divided into 100 shares. In order to finance his new product, the founder decides to organize a capital increase with an investment fund. L'Oiseau is valued at 10 million euros and the fund invests 2.5 million. The founder contributes 0.5 million. The total amount of the increase is therefore 3 million euros.

Before capital increase

Founder's ownership = 80%.
Ownership of his brother = 20%.

After the capital increase

Founder's holding = (80% x 10m + 0.5m) / (10m + 3m) = 65.4%.
Brother's ownership = (20% x 10m) / (10m + 3m) = 15.4%.
Fund holding = 2.5m / (10m + 3m) = 19.2

Let's check our calculations

80-65.4 = 14.6 corresponds to the dilution of the founder.

20-15.4 = 4.6 to his brother's

14.6 + 4.6 = 19.2, which is equal to the fund's holding.

Capital dilution: should we be afraid?

Equity dilution looks bad at first glance, but there are scenarios where it can be a good thing. Conversely, it is usually a targeted strategy with a specific end goal. For example, when a company issues new shares, it usually indicates growth. There are different scenarios where dilution can indicate positive changes and others where it can be a cause for concern.

One should not fear dilution either. Of course, the weight of the founders in the company's capital will decrease but it is possible to minimize this.

There are 3 methods for this:

First, by agreeing with the new investors on a high valuation of the company.
Then investors can subscribe to preference shares that will give them more attractive dividend rights but no voting rights.
Finally, it is possible to set up call option systems that will allow the founder to buy new shares of his company in the future at a predetermined price.

3 tips for startups to manage share dilution

Startups face several obstacles that established companies have already overcome: cash flow, for example. Raising capital through equity offerings (and therefore dilution) seems like an easy way to overcome these hurdles, but it can affect shareholder returns in the long run. This can be avoided.

Look for different financing options

Equity is valuable. It's not something that can be given away or thrown away lightly. It's the mindset you need to cultivate early on if you're an entrepreneur launching a startup or a finance team exploring equity financing options.

If you are new to the process, find an advisor who knows how to structure a company and limit the issuance of common stock. There are other ways to finance a business, detailed in the rest of this article.

Model what the dilution will be for different options

Do the math. Some business owners consider the potential increase in cash flow resulting from a stock offering, but fail to calculate the impact on existing shareholders. Those who buy shares in your company are among your greatest resources.

To do this, use a fully diluted capitalization table. It will show you the total number of shares outstanding, including totals for each option if exercised. Incorporate these numbers into your dilution model to understand the impact of issuing new shares.

Test your MVP to minimise costs

This does not affect dilution, but it is a good practice to adopt to control costs and streamline your business.

The lean startup approach is to launch only your minimum viable product (MVP), minimize costs and test assumptions using cost-effective marketing techniques and simple metrics. Done right, this method can eliminate the need to raise more money.

What non-dilutive financing solutions exist?

However, it is possible to finance without dilution. These are the non-dilutive financing methods.

Grant and bank loan

The bank loan is a financing solution widely used by business creators. A bank is still a company that seeks to minimise its risk-taking and optimise its profitability. To obtain a bank loan, you must therefore present your banker with a coherent project that includes sufficient guarantees in terms of potential market and viability.

Revenue Based Financing

Revenue Based Financing (RBF ) is a new method of financing based on a company's future revenues. In concrete terms, RBF enables you to transform future revenues into immediate cash flow based on vo. This enables you to unlock non-dilutive growth capital.

Karmen is a revenue-based financing solution for companies seeking short-term financing.

In less than 48 hours, Karmen can release funds to finance projects, customer acquisition costs or generate cash.

In addition to this speed of execution, revenue-based financing is a non-dilutive and more accessible financing solution.

At Karmen, we support the growth of your start-up with a 100% non-dilutive, digitalized financing solution in less than 48 hours!