Term Sheet Basics – Dilution

Dilution is a term that is frequently discussed in the context of preferred stock financings.  However, it is important to understand that there is a difference between dilution in the general sense and the type of dilution with respect to which preferred stockholders receive protection.

Dilution in the general sense just refers to the fact that when a corporation issues additional shares, the percentage ownership of the existing stockholders is reduced.  For example, if a company with 6,000,000 shares of common stock outstanding on a fully diluted basis ((A company’s common stock outstanding on a fully diluted basis is the sum of the number of shares of the company’s common stock that are: (a) outstanding, (b) issuable pursuant to outstanding convertible securities (like preferred stock), (c) issuable pursuant to exercisable securities (like options and warrants) and (d) otherwise reserved for issuance pursuant to the company’s option plan(s).)) sells 4,000,000 shares of Series A Preferred Stock in a financing, then the holders of the 6,000,000 shares of common stock go from owning 100% of the company to owning 60% of the company:

The previously existing stockholders have been diluted; more precisely, their ownership of the company has been diluted.  Some people like to talk about dilution in terms of a pie.  The previously existing stockholders in our example went from owning 100% of the pie to owning 60% of the pie.  Dilution is often seen as a bad thing because the previously existing stockholders are seen as owning a smaller portion of the same pie.

But what if the pie is getting bigger?  After all, the purchasers in the Series A Preferred Stock financing should be paying for their stock.  Let’s assume that the Series A Preferred Stock in the financing is sold at $0.50 per share.  This would imply a “pre-money valuation” for the company of $3,000,000 ($0.50 x 6,000,000) and a “post-money valuation” of $5,000,000 ($0.50 x 10,000,000): ((See my previous Founder Tip of the Week for a discussion of “pre-money valuation” and “post-money valuation:”))

Although the previously existing stockholders now own a smaller percentage of the company’s stock, and this has certain negative ramifications (including reduced voting power), their shares—their share of the pie—continues to be worth $3,000,000 while the company has raised an additional $2,000,000 of working capital.  Admittedly, this grossly oversimplifies the valuation of a company and its stock; a stockholder probably could not sell his common stock for $0.50 per share.  However, the takeaway here is that the value of the company is increasing, that the pie is getting bigger.

Preferred stock investors recognize this.  Accordingly, they seek protection from dilution (i.e., anti-dilution protection) only with respect to issuances by the company at a price per share lower than what they paid.  In our example, the Series A investors would receive anti-dilution protection only with respect to issuances of stock made at price lower than $0.50 per share.  We will discuss anti-dilution protection, including types, triggers and carve outs, in another Founder Tip of the Week.