Equity Dilution

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Dilution is the process wherein the company issues new shares which results in a decrease in percentage ownership of existing shareholders of the company. To understand dilution, one needs to understand a vital term known as “Option Pool”.

Option pool also known as Employee Stock Option Pool (ESOP) refers to the percentage of the company that is reserved for employees. Option pools are reserved by the investors in the company to hire the right talent which they believe will take the company forward and bring value to their investment.

The following example gives a deep dive into how dilution works and how ESOPs are incorporated by investors.

A company ABC Corporations has been formed. The founder of the company decided to keep 90% of the company himself and the rest 10% has been distributed among the engineers present in the firm.

The firm does well and attracts interest from various Venture Capital firms for seed funding. Finally, they settle with WhiteHat Ventures who agree to 20% equity and 10% ESOP post seed round of funding.

The value of the ESOP is being taken out of pre-money valuation. This means that after the investment in the seed round of funding, the option pool will be diluted as well. The math behind this is as follows:

  • Equity to be allotted to WhiteHat Ventures = 20%
  • ESOP post seed round = 10%
  • ESOP prior to the seed round can be calculated as follows:

(10% / (100% – equity to be allotted) ) x 100 = 12.5%

  • Percentage of equity with founders = (100% – 12.5%) x 90% = 78.75%
  • Percentage of equity with engineers = (100% – 12.5%) x 10% = 8.75%
  • ESOP 1 = 12.5%

Percentage Ownership after ESOP but before Seed Round of funding

Since WhiteHat Ventures have 20% of the equity, the percentage ownership is as follows:

  • Percentage equity with founders = 78.75% x (100% – 20%) = 63%
  • Percentage equity with engineers = 8.75% x (100% – 20%) = 7%
  • ESOP 1= 12.5% x (100% – 20%) = 10% (as agreed upon)
  • Percentage equity with WhiteHat Ventures = 20%

Percentage Ownership post Seed Round

The company did remarkably well and has gotten investors investing in it in Series A. The investors in Series A want 30% equity and ABC needs to maintain 10% ESOP post Series A round of funding.

  • Equity to be allotted to Series A investors = 30%
  • ESOP post Series A round = 10%
  • ESOP pre Series A round can be calculated as

(10% / (100% – 30%)) x 100 = 14.28%

So, we need a total ESOP of 14.28% prior to Series A

This is inclusive of the ESOP from the prior round which was 10%

Increment in ESOP = 14.28% – 10% = 4.28%

This 4.28% is further going to dilute you before Series A. If we assume that dilution in this round is only going to be 4.28%, then the following would happen:

  • Percentage equity with founders = 63% x (100% – 4.28%) = 60.30%
  • Percentage equity with engineers = 7% x (100% – 4.28%) = 6.70%
  • ESOP 1= 10% (will remain the same)
  • Percentage equity with WhiteHat Ventures = 20% x (100% – 4.28%) = 19.144%
  • ESOP 2 = 4.28%

This shows that the total percentage ownership is greater than 100% which is not possible, therefore the dilution that occurs due to ESOP 2 is greater than the pre-money increment in ESOP which is 4.28%

Let’s assume that the dilution caused due to ESOP 2 is ‘p’

We have:

63% x (1 – p) + 7% x (1 – p) + 20% x (1 – p) + 10% + 4.28% = 100%

Solving this equation, we get p = 4.75%

Therefore, the increment in ESOP of 4.28% causes a dilution of 4.75%

  • Percentage equity with founders = 63% x (100% – 4.75%) = 60.01%
  • Percentage equity with engineers = 7% x (100% – 4.75%) = 6.66%
  • ESOP 1 = 10% (will remain the same)
  • Percentage equity with WhiteHat Ventures = 20% x (100% – 4.75%) = 19.05%
  • ESOP 2 = 4.28%

Percentage Ownership after ESOP 2 but before Series A Round of funding

After Series A, the equity gets diluted by 30% since Series A investors get allotted wit their share of equity

  • Percentage equity with founders = 60.01% x (100% – 30%) = 42.00%
  • Percentage equity with engineers = 6.66% x (100% – 4.75%) = 4.67%
  • ESOP 1= 10% x (100% – 30%) = 7%
  • Percentage equity with WhiteHat Ventures = 19.05% x (100% – 30%) = 13.34%
  • ESOP 2 = 4.28% x (100% – 30%) = 3%
  • Percentage of equity with Series A investors = 30%

Percentage Ownership post Series A

This is how the concept of dilution works and this is then further carried on in further rounds of investment.

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