Equity dilution happens when a company issues new shares and an existing shareholder’s percentage ownership decreases, even though the number of shares they hold stays the same.
This guide covers the common triggers for dilution, how shareholders typically protect themselves against it, and where a share split fits into the picture.
Let’s begin.
What is equity dilution
Dilution happens whenever new shares are issued and a shareholder does not take up a proportionate share of them, whether the new shares go to a new investor or to other existing shareholders. The shareholder still holds the same number of shares as before, but the company’s total share count goes up, so that same number of shares now represents a smaller percentage of the company.
This is different from a shareholder actively selling or transferring shares where dilution happens passively, simply because more shares now exist in the company.
Dilution is not necessarily a bad outcome. Although a shareholder’s percentage ownership decreases, the value of their remaining stake may increase if the company successfully raises capital and grows.
More importantly, founders should ensure their decision-making rights are adequately protected through a well-drafted Shareholders’ Agreement (SHA).
Common triggers
Dilution can arise from a range of events as a company grows. Common triggers include:
- a new investor subscribing for shares in a funding round
- setting up or expanding an Employee Share Option Plan (ESOP)
- bringing in an additional co-founder after incorporation
- a follow-on funding round as the company raises further capital
- convertible instruments, such as redeemable convertible preference shares, converting into ordinary shares
For a closer look at how equity is typically allocated among founders and early stakeholders, see our guide to startup equity distribution.
Shareholder protections
Shareholders who want a say over dilution generally rely on protections negotiated through a SHA, rather than the Companies Act 2016 alone.
- pre-emption rights give existing shareholders first dibs to subscribe for new shares, allowing them to maintain their percentage stake
- reserved matters can require shareholder approval before new shares are issued, giving certain shareholders a veto
Even where these contractual protections are absent, shareholders may still benefit from the statutory pre-emption rights under section 85 of the Companies Act 2016. Subject to any modification or exclusion in the company’s constitution, new shares must generally first be offered to existing shareholders in proportion to their existing shareholdings before they are offered to anyone else. However, this only gives shareholders the right to subscribe for their pro rata entitlement, not the right to block an allotment if they choose not to take it up.
For more on this, see our guide to SHA founder protections.
Share split as a related consideration
A share split increases the number of shares in issue and reduces the value of each share proportionally, without changing anyone’s percentage ownership. Every shareholder ends up holding a larger number of shares, but each individual share is worth proportionally less, so no one’s overall stake in the company changes.
Share splits are typically carried out early while a company has a small shareholder base, such as a sole founder or a small group holding a limited number of shares. This gives the company a larger, more flexible share pool to work with before shares are allocated to a wider group of investors or employees.
Once other shareholders are in the picture, a split has to be applied proportionally across every shareholder holding that class of shares. For this reason, founders often consider a share split before bringing in outside investors.
Let ELP structure your startup equity
Whether it involves documenting a new funding round, setting up an ESOP pool, or negotiating anti-dilution protections in a shareholders’ agreement, structuring these arrangements properly upfront avoids disputes later. We assist founders and investors with drafting and reviewing the agreements needed to manage equity as a company grows. Contact us for an initial consultation.
