As a startup, you have to be aware of all aspects of running a business, and equity dilution is one of the more unrecognized situations that entrepreneurs face. Today we’re working with EIN filing service Gov Doc Filing to find out more about how equity dilution can affect you.
What is Equity Dilution?
Simply put, this term refers to the amount that your ownership of the company decreases when you add capital, or you increase the number of shares available to shareholders. At first, this can seem counter-intuitive, but equity dilution isn’t all bad. Let’s go over three elements you should know about it.
#1 Equity Dilution is Not Just About Stocks
Overall, any time you add value to your business with new investments or you increase the number of shares, equity dilution will occur. It’s critical that you understand this because it will lessen the shock when it happens. Furthermore, when the market cap of your company would be calculated in the future, it would include all past and present share prices. In a downturn, market capitalization can overestimate a company’s value that can eventually give your company to stand again in the market.
#2 Value is Better Than Percentages
When you first see your ownership go from 100% (or 50% or whatever) to a smaller amount, it can feel like you’re giving up a significant chunk of your business. However, you have to look at the value of that percentage. For example, if you own 100% of a company that’s worth $1 million, but then you add $5 million to the valuation and reduce your share to 45%, now you have $2.25 million instead. You have a smaller percentage, but more money overall.
#3 Dilution is Necessary
As your company continues to grow and thrive, you will have to seek out new sources of capital, which means that you will have to either increase the number of preferred shares (so people can buy them), or you will have to seek investment.
However, dilution is a smart move as long as you do it the right way. If you can wind up with more money at a smaller share, then it’s worth it. If you’re going to have a net loss, then it might be better to wait for a better deal.
As a startup, you have a lot on your plate, from your LLC tax form to business licenses. Understanding equity dilution will help you move forward the right way.