Stock dilution, also sometimes referred to as equity dilution, refers to what happens when a company decides to issue more stock to new investors. When the "float" (the amount of shares on the market) is increased, the people who already own shares now have a smaller percentage of shares. Stock dilution usually occurs during a company's start-up or venture capital raising phase.
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Things you need
Understand how a company divides up its initial stock. When a stock-issuing company is formed, there is a certain amount of shares that belong to the company. Those shares are then divided up among the principals of the company, such as the board of directors, chief operating officer and chief financial officer. For example, a company has 2 million shares of stock when it is formed and a board member is offered 5 per cent, or 100,000 shares, during the "pre-funding period."
Learn about the value of the company. As you get the company off the ground, there is essentially no value or assets. Therefore the value is essentially 0. This is because the company is still "pre-funded."
Understand what happens when investors come in and fund the company. They are going to offer you an amount of money for a stake in the company. Furthering the example above, say investors are willing to stake £1.3 million for 50 per cent of the company. This immediately gives the company a value. To calculate the value, perform a simple algebra equation.
Investment / Percent Ownership = New Value
$2,000,000 / .50 = £2,600,000
In this equation 50 per cent is changed to decimal form to calculate the equation. The equation essentially states if 50 per cent of the company is worth £1.3 million, then 100 per cent of the company must be worth £2 million. This is referred to as the "post-money valuation."
Determine how many more shares need to be added to the float based on the post-money valuation. Because you cannot take shares away from people who already have them, you must create new shares. To calculate exactly how many shares you need to add, you need this algebra equation:
x / (Original Shares Issued + x) = Percent Ownership
"x" represents the number of new shares that must be added.
x / 2,000,000 + x = .50
2,000,000 / (2,000,000 + 2,000,000) = .50
This means the company would need to add 2 million shares to the float to meet the new ownership demand.
Calculate how the new float dilutes the shares that you currently own. Using the example above, the investor was offered 5 per cent of the original float, which was 100,000 shares based on 2 million original shares. He now holds 100,000 shares out of 4 million. The equation becomes:
Shares Owned / Float = Percent Ownership
100,000 / 4,000,000 = .025
Multiply this by 100 to get a percentage of 2.5 per cent.
If further rounds of venture capital are added, the stock dilution continues to occur by recalculating these equations with the new numbers.
Tips and warnings
- While stock dilution is most commonly spoken of in venture capital, it can happen to a stock that is currently trading on the market. However, the math would be much simpler, since there is already a value to the company. You would divide the shares you currently own by the new float, or total number of shares on the market.
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