What does "dilution" mean to a startup founder?

Over on LinkedIn, this question caught my eye:

How much do founders get diluted through exit?

This isn’t a new question.I regularly answered it for founders, employees, and even angel investors during my time at Brobeck in Silicon Valley. There are lots of people concerned about “dilution” without really knowing what it is.

Dilution means owning less of the whole than you did before some event, typically an equity financing in this context: what this means is that, as several answers hinted, the infusion of cash into the company in exchange for equity results in the issuance of additional shares. A founder (or similarly situated party) now has the same number of shares divided by a larger number of total shares on a fully diluted basis; the lower percentage total signals the dilution.

However, that is less than half the story. The real issue, the one that founders should care about (other than the quasi-mystical point at which they cross below 50.1%), is whether they have been economically diluted. If equity is sold at an increased valuation to that at the time shares were acquired, the new financing dilutes your % of the shares at the same time as the value of what you have has increased. You are better off financially as compared to the past, and on a present-tense basis, you are at least break-even.

Short example:

  • 100 shares owned by Fran Founder. Fran owns 100%; value of company is $100; value of Fran’s stake is $100.
  • Investment of $100 by Ivan Investor. Pre-money valuation is still $100, so share price =$1  => 100 new shares issued.
  • Post-money: total shares, 200. Post-money valuation, $200 ($100 pre-money + $100 cash). Value per share, $1.
  • Fran Founder holds 100 shares worth a total of $100 that represent 50% of the company.
  • Ivan Investor holds 100 shares worth a total of $100 that represent 50% of the company.

This is dilution in the real world. Fran has a smaller percentage of a more valuable company, and measured at the moment of the financing, she has suffered no economic loss at all. Indeed, many would argue that the better-financed post-money entity is probably worth more than just the pre-money plus the cash, since the cash reduces risk and increases the likelihood that the company will achieve its business plan goals.

The purpose of this long segue is to help founders focus on the important issue, which is increasing the value of their companies. That, far more than worrying about percentage ownership, will enhance the value of what they own. One might write this off as the party line, a conspiracy concocted by VCs to ensnare founders and “steal” their companies. My evidence to the contrary is the fact that in the articles and certificates of incorporation that contain the terms of the preferred stock in which VCs invest, you will find nothing that addresses the ownership stake directly. You will, however, find antidilution provisions that are explicitly limited to economic dilution, i.e., the issuance of certain shares of stock below the price paid by an investor. The plain language tells me that VCs care about economic dilution and not about ownership dilution (as long as the economics are in line).