If you’re the sole founder of a startup, you start off owning 100% of the company. But as new capital comes in and employees are compensated with stock options, new shares are issued, and current shareholders end up owning a smaller, or diluted, percentage of the company. The more shares issued, the less ownership each existing shareholder retains. Startups typically go through multiple rounds of fundraising—Pre-seed, Seed, Series A, B, C, and later growth rounds—so the earlier you invest, the more dilution your equity will experience. In contrast, those who invest later face less dilution.
Convertible securities, like SAFEs and convertible notes, also cause dilution. SAFEs (Simple Agreements for Future Equity) convert to equity at the next funding round, usually Series A, often at a discount to reward early risk. Convertible notes, which accrue interest and convert to equity upon hitting a milestone, can dilute ownership with valuation caps and conversion discounts. Pre-money SAFEs postpone dilution until the next round, while post-money SAFEs specify ownership percentages upfront.
Each priced round of funding further dilutes existing shareholders by creating new shares for incoming investors. Your percent ownership depends on whether the valuation is pre-money (before the new investment) or post-money (including the new investment). For instance, if new Series B investors value a company at $3 million pre-money and invest $600K, they end up with a smaller ownership percentage compared to a post-money valuation.
Stock options, reserved for early employees and advisors, also contribute to dilution when exercised. These options add new shares, reducing the percentage ownership of existing shareholders. While dilution reduces ownership, it can indicate growth as the company raises more capital and increases its valuation, potentially boosting the value of your investment.
Ownership is crucial, especially when owning shares affords you voting rights. However, the value of your investment can decrease independently of ownership due to a down round, where new shares are issued at a lower price, reducing both the value and percentage of your stake. For example, if a company valued at $5 million in Series A drops to $3.8 million in Series B, your $800K investment may devalue to $640K, and your ownership percentage could drop from 16% to 14.8% due to the issuance of new shares.
To protect against dilution, investors can negotiate pre-emptive rights, allowing them to participate in future rounds to maintain their stake. These rights, however, are typically reserved for major investors and come with carve-outs that exclude certain issuances. Anti-dilution provisions in convertible preferred stock can protect value by adjusting the conversion price during down rounds, ensuring each share of preferred stock converts into more common stock.
While dilution affects potential earnings, the goal is for your investment to grow in value even as your ownership percentage decreases. For particularly successful investments, negotiating conditions that protect both the size and value of your stake is crucial. Understanding dilution and how it might play out can help give you a better sense of what your investment might one day be worth. Always review numbers and capitalization tables and model long-term dilution across various scenarios to better gauge the impact on your investment.