As companies raise capital, shareholders need to keep an eye on their changing ownership percentages and resulting stockholder dilution. If you start a new company with a partner, you each might own 50 percent of the company. And, as you take on more funding, your equity percentage begins to drop due to share dilution.
When you start a company, you might not have a lot of money to pay employee salaries. So, you need to incentivize them in another way. One of the ways to do so is to offer them stock options. As you grant stock options to your employees, you effectively give them an ownership stake in the company. It might not be a lot, but it will cause your equity percentage to drop. For example, if you issue four million shares to you and your partner and then add another 1 million shares through stock options, you have effectively diluted your ownership stake from 50 percent to 40 percent, as the employees now own 20 percent of the company.
The same dilution effect can happen if you go through multiple rounds of funding. If you don’t have enough capital to finance all of your company’s operations, you might need to raise money from venture capital or private equity. When you collect money from these offerings, they will expect to be rewarded with an equity stake in the company. You will need to negotiate with potential investors on a fair valuation of the company. Then, when you take that money from them, you will give them equity in your company and possibly provide dilution rights to yourself and other founders to curb the effects of dilution.
If your equity dilution is too high, you may have a hard time attracting new investors. If your investors believe that they have no potential growth opportunities because their equity is too limited, they may divest. So, how can you limit cap table dilution? Do not raise more money than you truly need to get to the next stage of your business. And, do not create a bigger option pool than you need. Always model your future dilution before you take on more investors or issue more shares. That way, you can prepare accordingly.