With each year the number of startups grows. A successful startup needs an idea and team to implement it, as well as necessary funding. Generally, startups do not have enough money to sustain themselves and tend to get investments from outside.
In the same time, investing in a startup can lead to the equity dilution of its founders. Read more of what an equity dilution is, why it happens and what consequences it has, as well as whether (and how) it can be avoided.
What is equity dilution?
Dilution is a decrease of equity ownership after an increase of the company’s statute capital and total number of owners.
Equity dilution is easiest to explain on the example. Let`s imagine a company with a capital of 10,000 USD and two owners, who own it 50/50.
If a third member joins the company and increases the capital by 2,000 USD, the shares of all previous owners will be proportionally decreased.
The total capital of the company will be increased (12,000 USD after the third member compared to 10,000 USD with two), but the two initial owners also will own it in a lower percentage.
How does an equity dilution in startups occur?
Equity dilution can be used for a variety of reasons, both positive and negative – for instance, in some cases dilution reduces the voting rights of an unwanted company member.
However, in startups equity dilution is often necessary to receive funding. Founders have 100% ownership of a new-created startup. By getting an investment they find funds they need and an investor, in return, gains a share in the company that may bring him or her profit in the future.
What are the consequences of equity dilution?
Equity dilution has both positive and negative consequences for startup founders.
The main positive consequence is obvious – after funding, the owners of the startup have an opportunity to develop their company. If a startup is successful, they can earn more profit compared to what they would have without investment. Moreover, if an investor owns a part of the company, he or she is personally more interested in its development and growth.
There are also some negative consequences of the equity dilution. First of all, founders lose some control over their startup – as a rule, their voting rights decrease proportionally. Besides that, they also could receive less profit in the end if the startup is not growing or fails (e.g. due to reduced dividends per share).
Potential positive and negative consequences should be estimated for each startup individually, so the founders could decide if it is optimal to receive funding in return for a share of the company or use other investment methods.
How to avoid equity dilution?
To avoid equity dilution, founders of the startup may choose other investment methods, which do not provide for a transfer of a share of the company to the investor (e.g. grants, loans or crowdfunding). There are also some country-specific non-dilutive ways to receive funding – for instance, in the USA a revenue-based financing is often used. It gives companies capital in exchange for a percentage of their future revenue.
However, it is almost impossible to avoid equity dilution of the founders in the startup if funding is received in exchange for a share of the company.
In some cases, founders may provide for so-called anti-dilution provisions under the USA law. They are used in companies with a capital divided into shares that are being sold at a reduced price. Ukrainian law does not provide for such provisions; however, it also does not explicitly prohibit them.
Anti-dilution provisions are very rarely used by the startup founders, as they exchange a share of a company for the investment. Yet if such provisions are applicable, they can be used in two ways:
- weighted average.
Full-ratchet is a less common anti-dilution provision. It applies the lowest sale price as the adjusted option price of conversation ratio for existing shareholders. In other words, if a new shareholder purchases shares at a rate of $1 per share while other shareholders bought sales at a rate of $2 per share, the number of shares of initial shareholders is doubled.
The weighted average is used more often. As the name implies, it is based on the average value of the share price and varies on the total number of shares issued by the company. If the weighted average formula had been used in the above example, the number of prices of the existing shareholders would have increased by approximately 1,4-1,8 times. The exact increase is difficult to establish, as weighted average depends on a number of indicators, which are determined on a case-by-case basis.
It is also possible not to avoid equity dilution as it is, but to minimize its risks – e.g. by identifying the optimal amount of an investment that would not dilute the founders too much or negatively affect management of the company.
Generally speaking, equity dilution in startups is almost unavoidable. However, if you need a detailed analysis on possibilities to minimize the negative consequences of equity dilution or non-dilutive investment methods, we recommend getting a legal advice from a professional lawyer who will determine the potential risks and provide the most optimal recommendations.