The Shifting Sands of Ownership Percentages

“Dilution” is one of the most discussed topics in the startup community. goodcounsel often advises startups on the implications of dilutions. In this post we describe some common scenarios, and explain what happens in terms of dilution.

Incentive equity grant

When a service provider (whether an employee, contractor, or advisor) receives incentive equity as part of compensation, there is no question that the founders and other equityholders are diluted. However, most people do not realize that the extent of the dilution depends on whether the company has an incentive equity plan in place. The below example helps illustrate this.

Let’s assume the company has 5,000,000 in fully diluted shares, and the prospective employee will receive 2% of the fully diluted shares. If the company doesn’t have an incentive equity pool, it means that her shares are not part of the fully diluted shares yet (see this blog post which explains why), so she would receive an option for 102,041 shares, assuming no fractional shares are permitted [x/(5,000,000 + x) = 2%]. If there is an incentive equity pool in place, it means that the shares in the pool are already part of the fully diluted shares, so the potential employee’s shares would come out of the pool. This means she would receive an option for 100,000 shares [2% * 5,000,000]. 

As the above example shows, it is more favorable for existing equityholders if there is an incentive equity pool in place, because a pool prevents further dilution every time a new service provider is granted equity.

Investment round

The size of the incentive equity pool is a common topic during negotiations with professional investors. These investors usually require that the incentive equity pool be “topped up” to a certain percentage – whether this occurs before or after the investors join the company as equityholders will affect the extent the founders and other equityholders are diluted.

“Reverse dilution”

“Reverse dilution” occurs when a service provider with unvested equity leaves a company (because the unvested equity is either repurchased by the company or forfeited by the service provider) and when the company is bought (because any unallocated equity is discarded). In each case, the result is that the remaining equityholders own a larger portion of the company.

In Conclusion

“Dilution” is something that founders are often concerned about (rightly so!). Reach out to qualified counsel if you need help understanding dilution and minimizing its effect.

Categorised as: Lawyering