How does equity dilution work for startups?
Equity dilution works when the same pie is divided among more people. The founder of a company starts by owning all the shares representing ownership of the company. Over time, other people receive pieces of equity in exchange for work (employee stock options), money (seed, angel and venture investors), or services (attorneys, directors, etc.)
Because the total percentage of equity will always equal exactly 100%, every time anyone gets another piece, by definition it “dilutes” all of the previous equity holders. Therefore, to avoid dilution to its existing equity holders, all a company has to do is not hire any more employees who get options, or take any more money from investors.
Otherwise, the laws of mathematics are pretty immutable, because “protecting someone from dilution” simply means that someone else is going to get doubly diluted.*
To see this graphically, check out the online Equity Simulator at OwnYourVenture.com
*Advanced Discussion: Note that because any method of handling “anti-dilution protection” has the effect of helping the equity holder who is being protected at the cost of someone else, this type of provision is hotly negotiated, and is always for the benefit of investors at a cost to the founders and employees. In the real world, it is completely and absolutely unheard of for founders or employees to get prophylactic anti-dilution protection, because of the Golden Rule of Early Stage Investing: “the investor with the gold makes the rules.”
That being said, there are certain circumstances where management (but virtually never founders or rank-and-file employees) has the negotiating leverage to get some protection for themselves. This typically happens when the company is facing tough times, and the value of management’s original options has greatly decreased to the point that the equity no longer serves as an incentive for staying with the company. In that case, faced with a potential exodus of management needed to keep the company going, investors might do a one-time management option grant to effectively protect some of their equity, or, if the company is positioned for sale, promise them a “management carve out” from the proceeds of the sale (which means management gets a stated piece of the cash up front, before the investors).
Rather more common is the practice of “evergreening” employee options, in which employees are given one or more additional option grants once their original grants have fully (or partially) vested. That keeps the carrot out ahead of the employee, with a continuing incentive for remaining with the company (otherwise, once all the options are vested after four years, there is theoretically no additional equity benefit to the employees in sticking around.)
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.