editione1.0.2
Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
The simplest example of dilution comes from adding another co-founder. This is different from adding another employee, which we will explore below. It is similar to the impact of selling shares in a priced round, but we will save that discussion for further on in our example so that we don’t tackle too many variables at once!
exampleJoe and Pete decide to add a technical co-founder, Rachel. After negotiation, the parties agree that Rachel will receive 15% of the company. Rachel buys her shares directly from the company out of the corporation’s authorized but unissued shares.
This is what the cap table looks like after Rachel purchases stock from the company such that she owns 15% of the issued and outstanding shares.
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Pete | 5,100,000 | 51.00% | 44.35% |
| Joe | 3,400,000 | 34.00% | 29.57% |
| Rachel | 1,500,000 | 15.00% | 13.04% |
| Issued and Outstanding | 10,000,000 | 100.00% | |
| Option Pool | 1,500,000 | 13.04% | |
| Total Fully Diluted | 11,500,000 | 100.00% |
Note that the number of shares Rachel is issued to reach 15% is calculated prior to taking into account the dilution of the option pool. If Rachel was super savvy on dilution, she might have tried to negotiate a 15% ownership after taking into account the option pool—that is, on a fully diluted basis. Or, in other words, she could have asked Pete and Joe to bear the dilution from the option pool—not her. Smart investors often ask for their ownership to be calculated on a fully diluted basis (meaning, for the pre-existing owners to take the dilution hit for the option plan shares set aside). You can see the impact of this change in the calculation below.
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Pete | 5,100,000 | 49.68% | 43.35% |
| Joe | 3,400,000 | 33.12% | 28.90% |
| Rachel | 1,765,000 | 17.19% | 15.00% |
| Issued and Outstanding | 10,265,000 | 100.00% | |
| Option Pool | 1,500,000 | 12.75% | |
| Total Fully Diluted | 11,765,000 | 100.00% |
Rachel ends up with an additional 265,000 shares by changing how she defines her 15% ownership. This is exactly how it works with investors as well. The advantage that Rachel gets in this latter calculation comes at the disadvantage of the other (prior) owners.
Since Pete and Joe are savvy negotiators too, they make the point that it makes sense that all founders should be subject to dilution from the option pool. So our example will continue on from Figure 2A.
As you can see from this simple example so far, when the company issues additional stock to founders or (later) investors out of its authorized stock, it dilutes the ownership of the existing stockholders. They own the same number of shares, but their percentage ownership of the company goes down.
Dilution occurs when a company issues new shares (other than in connection with a stock split or other adjustment affecting all shareholders in the same way). Shares may be issued for any of the following reasons:
When a company hires an employee and gives them stock options as part of their compensation, they usually issue the options out of the shares reserved for issuance under the company’s stock option plan (not the company’s authorized but unissued shares).
Joe and Pete hire a very experienced head of marketing and give them a stock option to purchase 3% of the company.
To translate the 3% of the company into a number of shares, Pete and Joe multiply 3% by the company’s issued and outstanding shares plus its entire stock option pool reserve. They are calculating the ownership on a fully diluted basis. This way, if they issue 3% to another executive the next week, that executive would get the same number of shares. Effectively, you don’t want each employee to dilute the next employee, especially since the board of directors may be approving option grants to five employees at the same time. This is how most companies translate negotiated percentages into share numbers; it does not have to be done this way, but it is the most common way.