Thoughts on startups by investors that
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Thinner Slices of an Extra-Large Pizza: Mathematical vs. Economic Dilution of Startup Equity

Back from a hiatus, it’s time to venture forward once more.  I appreciated hearing from those who asked about upcoming posts.  Thanks in particular to the reader who reminded me that Part II of “Bored” of Directors Can Become Clash of Titans is still in the queue.

Let’s get right down to business: Dilution of founders’ and other early shareholders’ equity in startups is frequently a subject of intense interest and debate.  Expert commentators including David S. Rose have written plenty on the subject; in fact, while I was editing this piece, David published a new post here at Gust: How does equity dilution work for startups?  David’s earlier answer to a Quora question, together with an overview by Rincon Ventures’ Jim Andelman, prompted my renewed interest in the subject.

As a young law firm associate learning the ropes, one approach I found helpful was to learn and contrast the concepts of mathematical vs. economic dilution of equity.  Viewing each as a discrete measure can make it easier to grasp what is often counterintuitive.

Entrepreneurs frequently think of equity primarily in terms of percentages such as 50/50 or 40/40/20 — not necessarily a bad idea at inception, or even throughout the lifecycle of a traditional business, such as real estate, where cash distributions, capital contributions, and allocations of profit or loss for tax purposes can be made accordingly.  The main downside of a percentage-centric perspective is that it quantitatively reinforces the intuitive but misleading impression that startup equity comprises a fixed “pie” that can only be sliced up into a finite number of pieces adding up to 100% — ultimately a zero-sum game.

What’s wrong with this picture?  To pizza lovers like me, the answer is obvious:  What really matters is the total volume you get to enjoy — a function of both the width of the slice and the diameter of the whole pie.  (Apologies to my Chicago friends: This metaphor ignores the depth of the dish.)  A growth company, by definition, is not a zero-sum enterprise.  As one well-worn saying asks, “Would you rather own 1% of a billion-dollar company or 100% of a worthless company?”  I’ll take 0.01% of Google, thank you very much (worth a cool $36 million as of this writing).  What if we follow President George W. Bush’s infamous exhortation to “make the pie higher“?

In pure percentage terms, dilution can be visualized as cutting the pie into more pieces, so cramming in more fractions entails “squishing” others’ existing slices to make them narrower.  That’s the concept of what some call mathematical dilution.  By definition, an equity percentage is a fraction, the denominator of which is the total number of outstanding (or issuable) shares, so issuing more shares will almost* always “dilute” existing shareholders in that sense. Yet what matters fundamentally is economic dilution:  Will adding newly issued shares make existing shares less valuable, and if so, by how much?

The simplest illustration is the first VC funding round of a new startup.  Before, it might have net assets that are near zero.  Suppose it raises $2 million at a $6 million pre-money valuation.  The founders go from owning 100% to 75% of the company — experiencing pure mathematical dilution — but they now own 75% of a company that has $2 million in current assets (cash sitting in the bank) when it previously had none.  That is not economic dilution, but rather its opposite (accretion).

If you read the “Dilution” section of an IPO prospectus, you’ll see that the opposite happens to investors in the new public shares.  Every S-1 contains the same language in Risk Factors that reads, essentially, “If you buy shares in our IPO, you will experience substantial and immediate dilution in the pro forma net tangible book value per share.”  That’s because whatever price the public investors are paying for their shares, the founders, employees and earlier investors invariably paid less (in cash; sweat equity is another story).  The measurable economic value of new shares issued to investors (“net tangible book value per share” in Accountantese) is immediately diluted by the existing shares, which make up the majority of the company’s stock.  The required “dilution table” quantifies this effect in a way that is supposed to be helpful to investors.

Being fluent in these concepts helps in many settings, such as negotiating terms with potential investors, co-founders and key employees.  Where the rubber really meets the road, in a nutshell, is ownership and control of the company.  Most entrepreneurs have more than a passing interest both in the economic value created from scratch by all their hard work and in the path that valuable enterprise takes in the years to come.  The themes of equity ownership and Board control will converge in my next post, where we’ll discuss clashes at the Board and shareholder level.  Stay tuned and thank you for reading!

* The exception is a stock split, where every share converts into, say, 10 shares.  Because all shares are split at the same ratio, ownership percentages remain unchanged.  It’s as if every dollar were exchanged for 10 dimes.

This article is for general informational purposes only, not a substitute for professional legal advice.  It does not result in the creation of an attorney-client relationship.

Written by Antone Johnson

user Antone Johnson Founding Principal,
Bottom Line Law Group

Antone is a business lawyer and executive advising technology and media companies, entrepreneurs and investors in corporate, commercial and intellectual property matters. Johnson is Founding Principal of Bottom Line Law Group, a business and IP law firm and was the former VP and head of worldwide legal affairs at eHarmony.

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