Why share dilution shouldn't keep you up at night

We've helped many, many founders share equity with their teams. 

We realise there's still a lot of confusion surrounding dilution; the impact issuing new shares has on existing shareholders.

So let's clear some things up. In this article, we'll explain what share dilution really is, ways to mitigate it and why founders should stop worrying so much.

What is share dilution?

Many people treat dilution with far more trepidation than it deserves.

To put it simply, when a company issues new shares, it reduces the ownership percentage of existing ones, diluting them.

While this sounds scary, it doesn’t necessarily mean that the value of these shares has decreased, which is what investors really care about at the end of the day. 

The most common reason for a company to issue new shares is to raise capital, but they also might choose to do so to reward employees through a company share scheme. 

In both cases, the result is a greater number of shares in circulation, meaning that the existing shareholders’ stake makes up a smaller proportion of the total. This means the percentage they hold is now lower, having been diluted.

But this isn’t always bad news. For example:

• By taking additional investment the company in question may be able to achieve growth that was otherwise impossible.
• Or attract and retain the best talent in today's highly competitive jobs market, by launching a company share scheme.

Both scenarios can be positive for the investor, as the result of both would likely be an increase in the value of all shares, including the original shareholders’. 

So, while on the face of it share dilution might seem concerning, the devil is in the details. 

Common concerns about share dilution

Two of the most frequent dilution-related objections we hear regarding company share schemes are: 

I don’t want my shares to be diluted.

My investors don’t want their shares to be diluted.

Both of these are completely understandable. 

Founders work hard to create successful enterprises, and investors deserve to receive a return on their investment for placing their capital at risk. Share dilution doesn’t have to be at variance with either of these.

Let’s tackle the first objection.

Founders don't want their shares diluted

In some cases, there’s little we can do to reassure people - some individuals just aren’t philosophically aligned with the idea of sharing equity. 

But speaking objectively: giving your team some skin in the game is proven to benefit your company’s bottom line.

Employees who are given equity are less likely to leave, are more engaged, and are more committed to the success of your company, than those without. All of this makes financial and ethical sense.

What’s more, a company share scheme doesn’t have to represent as large of a dilution of your founders' shares as you might think.

A typical founder will allocate somewhere between 5% and 15% of their equity to an employee option pool, which if it results in significant growth (and it normally does) is a small price to pay. ‘Pennies on the pound’, as they say.

The second objection is a little less black-and-white. 

Investors don't want their shares diluted 

Convincing someone to invest their hard-earned cash in your business is no mean feat, and founders are right to be wary of anything that might impact the value of these investments.

When starting a company share scheme, many will even rush to say, “can’t the options just be issued over my founders’ shares?” So as to avoid this altogether.

The simple answer to this question is: Yes, but you might not want to. 

As with most cases where equity is involved, the answer to this question isn’t straightforward, and it depends entirely on the founder and the context. 

Let's take a look at how you can avoid diluting your investors' shares, and why you might not want to. 

How to avoid share dilution 

There are a number of ways of creating a share scheme without diluting individual shares. Whether you should or not is another question entirely. 

Each method of avoiding individual dilution has its own merits and drawbacks. These methods include: 

1) Issuing options over a specific individual’s shares

It's possible to set up authorisation so that options are issued over a specific individual’s shares - which in this case might be over a founder’s shares, to avoid diluting their investors.

The only way to do this is to create a bespoke agreement with a lawyer, which can then be digitised through a platform such as Vestd for onward management once executed. These agreements can involve a great deal of a lawyer’s time, which means it gets expensive very quickly. 

2) Buy back shares

Two possibilities here:

a) To avoid diluting investors’ shares, you can buy back founders' shares into Treasury (meaning they are temporarily owned by the company), and then issue options over those shares instead.

But founders should proceed with caution, as once this is done it can’t be reversed - even if options are cancelled. And beware of the very specific rules on when a company can and can't buy back its own shares. Most companies are not eligible.

b) Or alternatively, founders can buy back shares, cancel them and then issue new options. The rules surrounding this are less restrictive than 2a, but still, not everyone qualifies. Learn more about share buybacks. 

It’s worth mentioning that the outcomes for methods 1, 2a and 2b, are identical. While the sequence of events is slightly different, once the options are exercised, the result is the same. The cap table won’t look any different. 

3) Issuing Unapproved Options

Another way to avoid diluting an investor’s shares is to issue unapproved options to the investor at the time that the employee options are issued.

You would issue them the number of options they would need to maintain their total percentage ownership at the agreed level once all of the new shares enter circulation.

This could be seen as unfair to others, as the shareholder(s) in question would have a stable percentage of ownership each time that new shares are issued, while everyone else’s reduces. 

Note: methods 2a, 2b and 3 can usually be done entirely via the Vestd app without a lawyer’s involvement.

4) Creating bespoke Articles of Association

The final way of mitigating the dilution of an investor’s shares is to draft bespoke Articles of Association that stipulate that a specific share class is never diluted, or contains certain “anti-dilution” clauses to reduce these effects. As with the first option, this involves lawyers, and so will cost a pretty penny. 

Plus the more complex the share structure is, the harder it is to understand, and the harder it is to understand, the less it will mean to option-holders. And that defeats the purpose. A simple scheme and share structure is far more likely to motivate stakeholders.

Why founders shouldn’t necessarily 'avoid’ diluting shares

The drawbacks of these methods likely outweigh the potential benefits - especially when you correct the misconception of share dilution as a whole.

Perhaps the biggest detriment of these is the lack of fairness. The majority of share schemes dilute all shareholders equally by default, and for good reason. 

Equity should, by its very nature, be fair - and founders should commit to sharing ownership fairly, or else they are missing at least part of the point. As such, it's important to choose partners and investors who share the same values. 

Another reason why founders shouldn’t be so concerned about dilution is that the positive impact of sharing equity has the potential to eclipse the effects of dilution entirely. 

After all, owning a slightly smaller percentage of a much bigger pie has to be better than owning all of something far smaller, surely? 

That said, if avoiding dilution is essential, know that there are methods for doing so.

If you'd like help navigating the complexities of sharing equity, book a free consultation with one of our equity consultants. They know this stuff inside-out. 

The original article first appeared on the Vestd blog.