⚖️ Understanding Dilution

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Practical Information - Understanding Dilution

Dilution occurs when a startup issues new shares, reducing the ownership percentage of existing shareholders, including founders. For instance, when you start your company, you own 100% of the equity. But as you bring in co-founders, employees, and investors, you issue new shares to them. If you start with 1,000 shares and issue 1,000 more to a co-founder, your ownership immediately drops to 50%. As the company grows and attracts more investment, this process continues, and your stake diminishes. By the time the company goes public (IPO), you might find yourself owning a small fraction of the original equity, even as the value of your shares increases.

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Dilution in Action: A Hypothetical Journey

Imagine you start a company and own 100% of the shares. You then bring on a co-founder and split the shares, leaving you each with 50%. To attract key employees, you create an option pool that further reduces your stake to 40%. You then raise a seed round, giving investors 20% of the company, which dilutes your ownership to 32%. As the company scales, you raise a Series A, B, and C, each time issuing new shares to investors. By the time you reach the IPO, you may find that after all the rounds and the option pool, your ownership has dwindled to just 15%. Although you own a smaller piece of the pie, the pie itself has grown significantly in value, meaning your 15% could be worth millions.

SAFEs and Dilution: A Stacking Effect

Simple Agreements for Future Equity (SAFEs) can complicate dilution further. SAFEs are convertible securities that allow investors to convert their investment into equity at a future date, often during a priced equity round or an IPO. Unlike regular equity rounds, SAFEs don't immediately dilute your ownership, but they stack up. When they eventually convert, they can result in significant dilution because multiple SAFEs might convert simultaneously, leading to a sudden and substantial increase in the number of shares. This "stacking" can be more dilutive than traditional equity rounds, especially if multiple SAFE rounds are raised. Founders must understand how SAFEs interact with future equity rounds to manage dilution effectively and retain as much ownership as possible while still attracting necessary investment.

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