Diluting shares can reduce the ownership percentage for existing shareholders, so tech employees should consider how that affects their compensation.
Receiving stock at a startup can seem like a ticket to riches. When you see headlines about newly minted millionaires from tech companies going public, it’s hard not to imagine what getting an ownership stake could do for your finances. But before you get too far ahead of yourself, it’s important to understand and be realistic about what stock compensation really means. In particular, it’s helpful to know how diluting shares affects your overall salary.
In this article, we’ll examine what stock dilution is and how it affects your compensation. Hint: it’s not always bad, but, as a startup goes through funding rounds, you may end up with a lower equity stake than you initially received. When negotiating your salary, you want to keep in mind the interplay between the number of shares you might get, the value of those shares, and how your equity stake may change as new stock gets created, thereby diluting existing shareholders.
Stock dilution is the result of the issuance of new shares, which reduces the ownership percentage that outstanding shares provide. By creating more shares, a company’s existing shares get diluted, as the overall pool has grown. So, each share accounts for a smaller percentage than it did prior to dilution.
In some respects, stock dilution is similar to other types of dilution, like adding water to a soap container. In that case, you might have more total volume of liquid, but each pump results in a lower concentration of soap. Diluting shares has a similar effect, with more total volume but with each share accounting for a lower concentration of the company than it did before.
However, the new issuance of shares isn’t necessarily the same as adding water as in the soap analogy, because the newly issued shares could have the same power as the existing shares. It’s generally not as if the new shares are weak like water and the old ones are strong like soap.
Cleanliness semantics aside, the point is just that diluting shares means a higher volume of total shares, with each share then accounting for a smaller ownership stake compared to pre-dilution.
Stock dilution directly affects existing shareholders, as it decreases their ownership percentage, even though the number of shares an individual owns could stay the same.
Example: For simplicity’s sake, suppose a startup has 100 existing shares. As an early-stage employee, perhaps you were given 10 shares, which equaled a 10% stake. But, in order to raise the next round of capital, perhaps the company issues 100 new shares that they sell to investors. Suddenly, with 200 shares in the market, those 10 shares you own as an existing stockholder equate to owning 5% of the company.
“Dilution can change both your financial stake in the company and how much control you have, so it’s important to understand how raising money can impact your ownership, especially early on,” notes Carta, an equity management solutions provider.
Diluting shares could potentially affect employee stock options (ESOs), which could be a key component of your total compensation. Issuing more shares could cause the price of the stock to drop, because a new investor might not see the value of the company increasing proportionally to the growth in the number of shares.
Example: Suppose a company has 1,000 shares valued at $1,000 each, giving the company a $1 million valuation. When issuing 1,000 more shares (meaning 2,000 total), if the value of each share stayed at $1,000, that would mean the company’s valuation would double to $2 million. More realistically, though, the share price would decline to match what investors see as an appropriate market cap.
“Dilution usually corresponds with a decrease in stock price. The greater the dilution, the more potential there is for the stock price to drop,” notes Robinhood.
If you’re expecting to be able to exercise options, then you want to maximize how much you can make from that transaction. But if diluting shares causes a stock price drop that puts you out of the money, or even just reduces your net gain, then you may come to regret accepting ESOs rather than a higher base salary.
Keep in mind, however, that the issuance of ESOs can also increase dilution. Maybe you work at a public tech company, in which case there could be common stock but also ESOs that could change the total number of shares.
As an article from the Wharton School notes, “when options are exercised the result is that more shares are in circulation, and that reduces, or dilutes, the value of shares previously in investors’ hands.”
Diluting shares can have a similar effect on restricted stock units (RSUs) as it does on stock options. For one, issuing new RSUs could be the result of issuing more shares overall, which would cause dilution for existing shareholders.
And if you have RSUs as part of your compensation, you want to pay attention to whether that’s based on a dollar value or a certain number of shares:
The simple answer is that startup employees should expect stock dilution, but the amount can differ significantly depending on factors like the size of the company and the current funding round.
Dilution can be more extreme through funding rounds for those with large stakes, such as founders. A Silicon Valley Bank article walks through four scenarios where a founder’s equity goes from 100% initially to roughly 50% at the seed round. By Series A, the founder’s equity has been diluted to 30-41% (depending on the scenario), and by the time they reach Series D, the equity is in the ballpark of 15%.
For other employees, stock dilution might not follow the same path, particularly if some equity comes directly from a founder’s shares. But, the general concept still applies. If you own a slice of the company and more shares get issued throughout funding rounds or eventually in an initial public offering (IPO), then you could end with a smaller ownership stake.
For employees with ESOs or RSUs at public tech companies, the value of shares — diluted or not — is clear based on the publicly traded price.
But for private companies, such as early-stage startups, there’s no publicly listed price. Instead, a 409A valuation could be used to determine the company’s fair market value and establish option prices.
As part of U.S. tax code rules, explains The Long Term Stock Exchange (LTSE), “options granted as compensation to service providers (employees or non-employees) have an exercise price, also known as strike price, equal to or greater than the fair market value of the shares underlying the options on the date the options are granted.”
In other words, 409A valuations can set the baseline for the exercise price. The more that a company’s value increases following a 409A valuation, the more valuable those options can become, which therefore increases employees’ overall salaries.
Considering that stock dilution is common among startups, especially at private companies going through funding rounds, it’s important for employees to realize how their initial stock grants may evolve.
When considering an offer to join a company, you might weigh accepting a lower salary in exchange for, say, 0.5% equity in the company. But don’t assume that you’ll still have 0.5% by the time the company goes public (if that even occurs). The number of shares you own may stay the same, but your ownership percentage may be far less. So, part of your compensation will generally depend on the equity value of the company at the time you exercise options and ultimately sell stock, rather than being fixed at the ownership percentage and share price at the time you’re hired.
With that in mind, employees may want to negotiate for clearer stock compensation, such as receiving a specific dollar value once vested, rather than an ownership percentage that could be diluted. But if you do receive compensation in the form of an equity percentage stake, know that the upside depends on the company’s value increasing.
Hopefully, even with dilution, you can own a small slice of a big pie, which ideally would be more valuable than a big slice of a small pie.
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