Understanding Causes and Effects of Equity Dilution
In the unprecedented world of startups, founders must prepare themselves for an inevitable dilution of their equity stake. This phenomenon is exemplified by Deepinder Goyal, the founder of Zomato, who holds approximately 4.19% of the company following its public listing. Similarly, Yashish Dahiya, co-founder of Policybazaar, retains a modest ownership stake of around 4.83% after a recent stake sale.
Ownership dilution is a common challenge for startup founders, affecting both their control and financial returns as they navigate funding and investment opportunities. For instance, in the case of Swiggy, co-founders Sriharsha Majety and Nandan Reddy each own approximately 4% and 1.6% after multiple funding rounds. This represents a significant decrease from their initial ownership percentages as the company raised capital to fuel its growth.
Meanwhile, Kunal Shah of Cred maintains a stake of around 12.05% as the company attracts significant investment. While this is a sizable stake, it has been diluted over time as Cred attracted substantial investments from marquee investors like DST Global, Sequoia Capital, and Tiger Global.
While equity financing can be a powerful mechanism for raising funds, it involves relinquishing a part of the company’s ownership. Therefore, it makes good fiscal sense for entrepreneurs to understand equity dilution comprehensively. This article stresses the causes and effects of equity dilution and how it impacts ownership percentages, voting power, and overall company valuation.
Definition of Equity Dilution
Equity dilution is the decrease in ownership percentage experienced by existing shareholders when a company issues new shares. It usually occurs during fundraising rounds such as Initial Public Offers (IPOs) or Follow-on Public Offers (FPOs) and is alternatively called share dilution or stock dilution.
Equity dilution can be understood through a simple analogy: when the same pie is shared among additional individuals, each person’s slice becomes smaller, representing a smaller stake in the company. It can be calculated using the formula:
Dilution = Number of existing shares / Total number of existing shares + Number of new shares added.
In addition to this, several other factors must be taken into account during the calculation process:
- Issuance of new shares from equity investment.
- Conversions of convertible notes with warrants, valuation caps, and/or discounts.
- Issuance of new options before and/or after the fundraising round.
- Shifts in company valuation.
- Repurchase of stock as part of the new funding round.
Here’s a case study of Vodafone Idea, which faced challenges in the telecom market in 2021 when the Indian government acquired a 35.8% stake in the company at a price significantly lower than the market value. This acquisition sharply reduced the ownership percentage of existing shareholders.
To understand its implications, it’s essential to explore how equity dilution occurs in different scenarios.
The Process of Diluting Equity
Equity dilution occurs when a company issues new shares during the fundraising rounds. It occurs through financing alternatives, including venture capital investments, initial public offerings, and employee stock options. During this phase, whenever an investment is made in a startup, its valuation increases with a simultaneous decrease in the owner’s equity, as it is shared with investors.
This process can take place through several mechanisms, including:
- Initial Public Offering (IPOs): During this stage, a company issues shares to the public for the first time, leading to the dilution of existing shareholders.
- Venture Capital Investments: Startups seeking venture capital offer equity in exchange for funding. This kind of investment involves substantial dilution of existing shares.
- Employee Stock Options (ESOPs): ESOPs are a benefit plan companies offer employees, such as direct stocks, bonuses, or compensation packages. When ESOPs are exercised, new shares are issued, reducing the percentage of ownership held by existing investors.
Example: In a notable instance of equity dilution, Flipkart's founders Sachin Bansal and Binny Bansal experienced significant reductions in ownership stakes over multiple funding rounds.
By the time Walmart acquired a 77% stake in Flipkart for $16 billion in 2018, Sachin Bansal's stake had been diluted to 5%, while Binny Bansal held approximately 4.24%. In 2023, Walmart further paid $1.4 billion to acquire stakes from investors like Tiger Global and Accel Partners, valuing Flipkart at $35 billion. This example illustrates how raising substantial capital through strategic investments can dilute equity for existing shareholders, including founders.
Causes of Share Dilution
Equity dilution is a common aspect of a startup's growth journey, typically triggered by various events that can reduce the founders' ownership. The following are the primary causes of share dilution:
Granting Stock Options
Companies offer ESOPs (Employee Stock Options) in the form of bonuses and compensation packages to retain employees. ESOPs can cause dilution in two ways:
- Percentage Dilution: When a shareholder’s ownership percentage reduces through the issuance of new shares, it is referred to as percentage dilution.
- Value Dilution: Value dilution occurs when new shares are issued at a price below the current fair market value. When new shares are issued at a discount to the prevailing market price, the total value of investors' holdings can decrease.
Recur Insight: Startups can mitigate value dilution by issuing ESOPs at a fair market value and replacing secondary shares with primary ones. Although ESOPs in entirety can dilute equity, they serve as an important factor in retaining talent within the company.
Convertible Securities
Convertible securities are debt instruments often used by startups to raise capital. When converted into common stock, convertible securities can dilute equity in some situations due to a conversion feature that allows shareholders to convert their investments into common shares at a specific conversion rate. This adds up to the total outstanding shares, diluting existing ownership. Convertible securities include:
- Valuation Cap: A valuation cap sets the maximum amount a startup can convert into equity. If the startup’s valuation reaches a substantial level, it can severely dilute the equity.
- Discounts: Through a conversion discount, investors can convert their securities at a lower price than future investors, leading to the issuance of more shares.
Also Read: Convertible Loans as a Financing Option for Startups: What You Need to Know
Recur Insight: To minimize dilution during your next fundraise, consider diluting 1-2% less, using equity capital as a strategic runway to raise debt capital for operations. This approach helps preserve ownership while ensuring sufficient capital to support business growth.
Seeking Additional Capital:
Startups require additional capital for various reasons, including capitalizing on growth opportunities, managing operational expenses, or settling existing debts. This is rampant in funding rounds where startups seek investment to expand their business. The issuance of new shares increases the total outstanding shares, diluting shareholders' ownership stake.
Acquisition:
Another major cause of equity dilution is acquisition. During acquisitions, companies exchange shares with the acquired company's shareholders or issue additional shares as part of the purchase price for another company, leading to a significant dilution. Let’s understand this through an example:
For example: In 2022, Walmart acquired a 77% stake in Flipkart for $16 billion, making it one of the largest e-commerce deals globally. Before this acquisition, Flipkart's founders, Sachin Bansal, and Binny Bansal, collectively owned a significant portion of the company.
However, after the Walmart deal, Sachin Bansal's stake was diluted to just 5%, while Binny Bansal's ownership decreased to around 4.24%. Sachin Bansal eventually exited Flipkart completely by selling his remaining stake to Walmart, while Binny Bansal remained a minority shareholder.
Issuance to Service Providers:
Small companies may occasionally issue shares to independent service providers or contractors as compensation instead of cash payments. This practice can lead to dilution, as the total number of shares increases when distributed among service providers. Startups often use this approach to conserve cash while attracting talent and expertise.
Pros and Cons of Equity Dilution
“The last thing a founder wants to do is give away 40, 50, or 60 percent of the company before they've even raised a Series A, which I've seen many times.”
~ Jim Marshall
Fundraising is one paradoxical decision and imperative throughout every startup’s journey. Despite the effects of equity dilution, its advantages can not be understated. Let’s explore its pros and cons:
Pros:
Increased Capital:
A prime benefit of equity dilution is the influx of capital that startups can leverage for crucial business decisions, including investing in technologies, entering new markets, and, most commonly, expanding operations. Hence, by diluting a percentage of their stake, owners can escalate their business to new heights.
Enhanced Expertise:
When new investors join a company, they bring their unique expertise, networks, and knowledge. These resources can prove extremely valuable for any startup, helping it scale and boost its competitive advantage.
Improved liquidity:
Issuing new shares improves liquidity, making it easier for startups to meet their short-term obligations and attract more investors. Raising capital by diluting equity also increases a company’s ability to weather financial challenges.
Cons:
Decreased Ownership:
The biggest drawback of equity dilution is the reduction in an individual shareholder’s ownership. The issuance of new shares directly affects the stake of existing shareholders, leading to a loss of control over business matters.
Decline in Earnings Per Share (EPS):
Earnings per share (EPS) indicates the amount of profit each outstanding share of common stock earns and is calculated by dividing the company’s net income by the total outstanding shares. If the company’s profits do not grow at the same rate, these outstanding shares may result in a decline in EPS, inviting a negative perception from investors.
Loss of control:
When a company gets diluted, it loses its decision-making power to new shareholders, especially institutional investors and founders. This can lead to potential conflicts or disagreements over business decisions as new shareholders may have distinct priorities.
Effects of Equity Dilution
Understanding the effects of equity dilution is essential for making informed decisions about funding and growth strategies. Here are the critical effects of equity dilution:
Financial Impact:
The implications of equity dilution can be detrimental to startups. Equity dilution impacts the financial metrics of a business in the following ways:
- The portfolio value of existing shareholders declines due to a decrease in their ownership percentage.
- Share price is affected, leading to a potential drop in stock value.
- Earnings per share (EPS) declines since profits are spread over many shareholders.
For example, if a startup has 10,000 shares outstanding and issues an additional 1000, the total will increase to 11,000. In this case, if the company has a cumulative earnings of Rs. 10 lakhs, the EPS before dilution would be Rs. 100 (10 lakhs/ 10000), but after dilution, it would drop to Rs. 90.91 (10 lakhs/ 11000).
Impact on Voting Power:
Equity dilution critically impacts businesses by reducing the voting power of existing shareholders. When the total number of shares increases, it reduces the percentage of shares held by current shareholders, diminishing their influence in company decisions. New investors with contrasting opinions and visions for the company can make decisions that existing shareholders may disagree with, leading to disagreements or disputes of interests.
Change in Control and Value:
Founders and existing shareholders may find their ability to influence key decisions reduced, especially if new investors hold substantial stakes. This shift in control can impact the company's direction and strategic decisions. Additionally, the overall value of shares may change as the market adjusts to the increased number of outstanding shares.
Picture this: A startup raises capital through a funding round, substantially increasing outstanding shares. This could diminish the founders' ability to make unilateral decisions, as they may experience a change in control. Further, if the market perceives dilution negatively, it could affect the value of shares and eventually cause a decline in its price.
How to Manage Equity Dilution
Managing equity dilution can be scary at times if not handled correctly. It poses a common challenge for founders, particularly in the startup ecosystem. However, with the right strategies, equity dilution can be managed. Let’s uncover a few of them below:
Plan Your Funding Rounds:
Startups raise capital during funding rounds. Strategizing and planning these rounds can prevent unnecessary dilution. Founders must practice caution while raising funds and avoid deluding themselves into thinking that ‘raising a large funding round is the hallmark of success.’ Raising capital that surpasses their needs may lead to inefficiency and distract founders from their business goals.
Use a Cap Table:
A cap table or capitalization table lists the number of shares and the ownership percentage of all shareholders in a startup. This is a structured approach to managing equity dilution effectively. Founders must update and analyze the cap table consistently and predict different funding scenarios, its impact on ownership stakes, and its dilution effects.
Set Favorable Terms:
Every investor has criteria that define the kind of companies in which they want to invest. When raising funds, it is considered good practice to analyze every investor and ensure that their terms and conditions align with your startup’s goals. These terms could include valuation caps, discounts, and other conditions that minimize dilution. It’s all about playing smart when diluting stakes. Founders can attract the necessary investment by negotiating dilution terms with investors and protecting their ownership stakes.
Consider Alternative Financing:
There are several non-equity options in the financing world. Alternatives such as revenue-based financing, venture debt, or a leading debt marketplace have also been gaining popularity. Raising non-equity and collateral-free capital is possible with Recur Club. It is India’s fastest-growing capital platform, working toward filling the country's credit gap.
Review Equity Grants:
A proven strategy to manage equity dilution is to evaluate equity offered to employees and stakeholders. Founders must examine equity grants or compensation structures in the form of ESOPs and manage the size of the option pool. This helps in mitigating the dilution impact on existing shareholders.
Key Takeaways
In summary, familiarizing oneself with the causes and effects of equity dilution can help founders foresee their startup’s growth. Startups must meticulously consider financing decisions and implement strategies to minimize dilution and maintain ownership, especially when seeking new investments.
At Recur Club, we recognize the complexities associated with managing equity dilution. Therefore, we offer tailored and innovative financing solutions to startups in multiple sectors, including SaaS, tech, D2C, and manufacturing.
If you are willing to explore other financing alternatives, schedule a call with a Recur Club expert to discuss them further!
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