Dilution occurs when a company issues new shares that result in a decrease in existing stockholders’ ownership percentage of that company. It can also occur when holders of stock options (such as company employees) exercise their options. When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.
However, the value of the dilution taken by existing investors depends less on a percentage basis than on the relative values of the stock before and after the dilutive event. For example, if the holders of the 6 million shares each purchased stock when the value was $0.01 per share, but the 4 million shares were sold at a value of $1.00 per share, then the value of the existing holders’ shares just went on paper from $60,000 to $6 million, a 100x increase. So although the existing stockholders own less of the Company on a percentage basis, they are happy because the Company, and their shares, are worth much more on the whole on a valuation basis.
It would be different, however, if the pre-money valuation of the Company in the new financing is lower than when the existing stockholders purchased their shares. That is called a “down-round” and results in a worst-case scenario for existing stockholders: they are getting diluted on both a percentage basis and a valuation basis.