Dilution often sounds more complicated than it is because fundraising conversations quickly move into percentages, valuations and fully diluted ownership. At the centre of it, however, is a simple idea. If a company creates more shares and gives those shares to new investors or employees, the existing shareholders may own a smaller percentage of the company afterwards even though the number of shares they personally hold has not changed. Nothing has been taken away from them. The total ownership of the company has simply been divided into more pieces.
The percentage changes because the total number of shares changes
Assume two founders own all the shares in a company between them. If the company later issues new shares to an investor, the founders still hold the same number of shares they held the day before the investment. Their percentage falls because the investor's shares have been added to the total. This is the denominator people are referring to when they talk about dilution.
That is why percentages should never be discussed without asking what number of shares sits behind them. A founder may hear that an investor is taking 20% of the company, but the effect on the founders can also depend on whether an employee option pool is being created before the investment, whether earlier SAFEs or notes are converting at the same time and whether any other shares are being issued as part of the transaction. The headline percentage tells only part of the story. The cap table shows how the pieces fit together.
Dilution is not automatically a bad outcome
Founders sometimes react to dilution as though every reduction in percentage is a loss. That misses the reason companies raise money in the first place. Owning 100% of a business that has very little capital is not necessarily more valuable than owning a smaller percentage of a company that has raised enough money to hire, enter new markets or build a stronger product. The sensible question is not whether dilution exists, because most companies that raise equity will experience it. The question is what the company receives in return and whether the new ownership makes sense for the stage of the business.
This does not mean founders should be indifferent to dilution. Giving away too much too early can leave very little room for future rounds, employee equity and the founders themselves. The company may later discover that the people still doing most of the work have a much smaller stake than expected. That is why dilution should be modelled before shares are issued rather than calculated after the documents have already been signed.
The option pool can change the founder's percentage before the investor comes in
Employee option pools are one of the places where founders can be surprised. An investor may agree to invest for a particular percentage of the company but also require the company to create or increase an option pool for future hires. If that pool is created before the investor's shares are calculated, the dilution from the pool may fall mainly on the existing shareholders. The investor then buys into a company that already has the enlarged pool reflected in its ownership.
There is nothing inherently improper about that structure. Investors often want to know that the company has enough equity available to hire the team needed after the round. The important point is that the founders should see the effect in numbers before agreeing to it. If the company already has enough unused options for its near term hiring plan, it may not need a large additional pool simply because a standard percentage appears in the term sheet. The pool should follow the hiring need, and the cap table should show clearly who bears the dilution created by it.
SAFEs and notes can make the ownership picture less obvious
A founder may look at the current cap table and see only the founders and perhaps a few early investors. That table can be misleading if the company has also raised money through SAFEs or convertible notes. Those SAFEs and notes may not yet appear as ordinary shares, but they are designed to turn into equity later. When the next priced round happens, several of them may convert at different prices depending on the terms agreed when the money was raised.
Founders should look at both the current cap table and a model of what it could look like after those rights turn into shares. Otherwise, a round that appears to sell 15% or 20% to a new investor may result in a much larger overall change once earlier SAFEs, notes and the option pool are taken into account. That does not mean the company should avoid SAFEs or notes. They can be useful fundraising tools. Founders simply need to remember that money raised today can affect ownership later even before new shares have formally been issued.
Model the round before negotiating from percentages alone
A useful fundraising model should show the founders what everyone owns before the transaction and what they are expected to own afterwards. It should include the new investor, any SAFEs or notes that will turn into shares, and the option pool on the basis actually being discussed. If there are different scenarios, those can be shown side by side. This is much easier to understand than trying to hold the entire transaction in your head while reading a term sheet.
Once the numbers are visible, the commercial conversation becomes better. The founders can see whether a requested option pool is larger than the hiring plan requires. They can understand how much earlier fundraising will convert into shares. They can compare one valuation with another in terms of actual ownership rather than only the headline figure. Dilution is therefore not a mysterious legal mechanism. It is the result of changes to the company's ownership. Founders who understand those changes before signing are in a much better position to decide whether the round works for the business they are trying to build.
This article is general information and not legal advice. For guidance on your specific circumstances, speak with us directly.