Equity dilution is one of the subjects that always left people perplexing. Founders often ask this question to themselves; how can I prevent dilution? And most professionals will say, you cannot.
That’s not solely true. Equity dilution can be a smart move, or it can make things worse for you. Founders can circumvent costly mistakes with their equity by comprehending which terms affect stock dilution the most so they can identify and avoid such pointless dilution.
Defining equity dilution
Primarily, equity dilution is the reduction of proprietorship as a result of new shareholders in the business post company formation. Dilution can happen when one raises a preferred round or when one allocates stock options as compensation to employees. Dilution can also occur due to convertible security, debt that converts to equity during the preferred round.
Also Read: What are Masala Bonds and their Benefits?
Here are the 5 terms to know for equity dilution mainly
When an investor gives you the term sheet, it holds specific negotiable levers listed in the form of individuals terms. There will be more terms on the term sheet than we are going to discuss here.
Term #1 – number of shares
You should know few elements within allocating share, including your valuation and your option pool.
How does the valuation affect the dilution?
Deciding what percentage of the company an investor possesses, and that’s why how many shares have, relies on two things; the value of the company and how much money is being invested. You will have to calculate your company’s pre-money and post-money valuation to know how much dilution to expect precisely.
How do option pools affect dilution?
Investors often need companies to grant shares in an option pool for future employees with stock-based compensation before their investment, meaning current shareholders will be diluted due to creating an option pool and the pending investment. In contrast, the new investors would skirt dilution during that round.
The main takeaway from this term is that the number of shares you allocate would instantly dilute your proprietorship stake. Remember, your proprietorship stake is not the same thing as the value of your equity. If one owns 50 percent of nothing, the one has a 50 percent proprietorship stake and nothing to show for it.
Term #2 – liquidation preference
It gives shareholders first dibs during the phase of liquidity. It means that shareholders with liquidity preference obtain their money before anyone.
Suppose if one sees 1x liquidation preference, that ensures that investors would break even along with their initial investment in full before common shareholders begin partaking in this distribution.
Nonetheless, if one sees a liquidation preference that increases the rate of return, for instance, 4x, then the shareholder will obtain 4x of their initial investment before others. This can go out of bound quickly, leaving others empty-handed. Generally, investors opt for a 1x conversion rate to common and 1x liquidation preference to obtain their money back.
Term #3 – the rate of conversion to common
It is only applicable when preferred stock is exchanged for the common stock during distribution circumstances like an exit. It enables the shareholder to convert his/her shares to common at a multiplied rate, such as two times of what they initially owned.
Although preferred stock comes with specific negotiated benefits, it is often more beneficial for investors to let go of their preferential stock and partake in common stock. If that is the scenario, the shareholder will waive all his/her preferred rights.
Also Read: Understanding Employee Stock Options (ESOP)
Term #4– partaking rights and caps
Participation rights can be dense. They enable the shareholder to act as a common stock while keeping all his/her other preferential terms.
If they have participation rights, then they will not have to waive their preferred stock rights to convert into common.
Participation right generally contains a cap. It means they receive all the benefits of their preferred stock and then go on to partake as common stock with a threshold. A partake cap will usually be 2x or 3x of investment.
If they do not have a cap, they can benefit from their preferred stock and then partake with common forever, diluting other equity value of the shareholders when there is no issue of bonus shares to the shareholders.
Term #5 – Cumulative Dividends (cash and PIKs)
There are two kinds of cumulative dividends, cash and PIK (payment in kind). Both acts act as a form of interest with set terms for how much accrues and how that accrue method is calculated, such as simple or compounded interest.
Few things to remember about cumulative dividends;
- Cumulative dividends paid in cash are common.
- Paid in kind cumulative dividends increase shares eventually.
- Both types of cumulative dividends are generally paid during a liquidation event.
Cumulative dividends would generally keep accruing until a liquidation circumstance. It could be difficult for founders and shareholders to incentivize the company to sell quickly to stop the clock.
PIK dividends are paid in shares instead to cash. Relying on how you establish the accrual method and percentage, you can end up with broad proprietorship dilution by offering shares to pay the dividends.
Figuring out how much cumulative dividend would affect your cap table relies on your situation. In a growing company, a cumulative dividend with an acceptable interest rate could be no big deal. In contrast, for an early-stage start-up, dilution could be painful as a result of PIK dividends. No one formula fits for all. Therefore it is better to know what suits you best.