What is dilution in a capital increase? How to calculate it?

After a capital increase, dilution represents a “reduction” in their percentage of ownership for existing shareholders.

When a company carries out a capital increase (issue of new shares in addition to existing ones), investors who buy those new shares acquire a part of the ownership of the company. This has a direct effect on the% of ownership of the original shareholders, which is reduced as a result of the increase in the total amount of shares outstanding.

In other words, the dilution represents a “reduction” in their percentage of ownership for existing shareholders, since, after the expansion, their share is divided by a larger number of shares. This, it is very important to note, does not necessarily imply a reduction in the total “value” of your shares. Although dilution can be a natural consequence of a company's search for funding and growth, it is important that existing shareholders understand their impact on their voting rights, decision-making and the total value of their investment.

For example, if a capital increase implies the loss of control of current investors and the entrepreneurs themselves over the company, what motivates entrepreneurs to seek additional funding through a new round of funding? Raising capital is a strategic step that companies take to ensure that they have the necessary resources to carry out various initiatives and achieve objectives that promote their growth and development. Some of the most common reasons behind a capital increase include:

  • Financing for growth: One of the most common reasons for carrying out a capital increase is to obtain the necessary funds to expand operations and increase market presence. These funds can be used to increase production, enter new markets, launch new products or services, and/or strengthen the customer base.
  • Investment in new projects: Companies can carry out a capital increase to finance research and the development of new innovative projects. This could include exploring new technologies, creating revolutionary solutions, or expanding into areas of strategic opportunity.
  • Team expansion: As the company grows, it may be necessary to hire new employees and expand the team to manage larger and more complex operations. Raising capital can provide the resources needed to hire and train new talent.
  • Acquisitions and mergers: When a company plans to acquire or merge with another, it may require a capital increase to finance the transaction. The funds raised can be used to buy other companies or to effectively integrate assets and operations.
  • Debt reduction: In some cases, companies can use funds from a capital increase to pay off existing debts. This can help improve financial health and lower interest costs.
  • Infrastructure and Technology: Modernizing infrastructure, equipment and technological systems can require significant investment. A capital increase can provide the necessary funds to improve operational efficiency and remain competitive in the market.
  • Compliance with regulatory requirements: In certain industries, companies may need to comply with specific regulatory or financial requirements that require a capital increase. This may be necessary to maintain licenses, comply with minimum capitalization standards, or other regulations.- Strategic opportunities: Companies can take advantage of strategic opportunities, such as investments in promising startups or joint projects with other market players. Raising capital can provide the resources to capitalize on these opportunities.

As we can see, capital raising is a versatile tool that allows companies to finance a variety of initiatives, from organic growth to exploring new opportunities and improving their competitive position in the market.

Causes and effects of dilution

The dilution affects both the participation and the voting rights of the company's original shareholders. But why? Prior to the issuance of new shares, the original shareholders hold a specific interest in the company, which is expressed as a percentage of the total outstanding shares. But, as we have already mentioned, when new shares are issued and sold to new investors, the total stock base increases. This means that the share of the original shareholders, expressed as a percentage, is automatically reduced. Although your number of shares may remain the same, your ownership relative to the total decreases. And, since shareholders tend to have voting rights proportional to their ownership in the company, when their percentage of participation in the company is diluted, their influence on decision-making also decreases. Therefore, the more shares they hold out of the total, the greater their influence on corporate decisions through voting. This can be especially relevant in important situations, such as the election of the board of directors, the approval of significant changes in strategy, or decision-making that require shareholder approval.

Practical example:

If a startup has 1,000 shares outstanding and an original shareholder owns 100 shares: that investor will have 10% (100/1,000) ownership and voting rights. If the company issues 500 new shares to raise funds, the total of outstanding shares increases to 1,500. In this context, and if the investor does not participate in this expansion, he will keep his 100 shares, but his ownership is reduced to 6.67% (100/1,500), which directly affects his influence on decisions and voting rights. This phenomenon must be carefully considered when making decisions related to the financing and growth of a company.

Dilution formula

Calculating dilution involves determining how the issuance of new shares affects the ownership and participation of existing shareholders. On the one hand, simple dilution focuses on how the issuance of new shares affects the ownership of an existing shareholder in percentage terms. The formula for calculating the simple dilution is the one that follows:

dilución simple

Simple Dilution Example:

If a startup has 1,000 shares outstanding and issues 500 new shares for funding, after the issue, the total number of outstanding shares will be 1,500. So the simple dilution for a shareholder who originally held 100 shares will be: Simple Dilution = (500/1500) x 100 = 33.33% This means that the ownership of the original shareholder is diluted by 33.33% due to the issuance of new shares, leaving their ownership at 6.67%. And, on the other hand, the full dilution takes into account not only the common shares issued, but also the effect of all convertible securities (such as options and convertible bonds) that could increase the number of shares in circulation in the future.

The formula for calculating the full dilution is the one that follows:

dilución completa

Full Dilution Example:

Following the example above, in addition to the 500 new shares issued, let's suppose that there are also 200 stock options that could be converted to common stock in the future. So, the total number of shares on a fully diluted basis would be 1700 (1500 common shares + 200 of convertible options). In this case, the participation in the company would be further reduced to 5.88% (100/1700), leaving the formula as follows: Full Dilution = [(500+200)/(1500 + 200)] x 100 ≈ 41.1% In this case, the investor's share in the example would be 5.88%.

Additional Considerations

  • Simple dilution tends to overestimate real dilution, since it does not take into account other instruments that can potentially be converted to shares in the event of the same capital increase.- Full dilution is more accurate, since it considers both existing shares, new shares issued and those other financial instruments issued in the past for which the capital increase acts as a trigger for conversion into shares.

As we said at the beginning of the article, it's important to keep in mind that full dilution doesn't necessarily mean that current investors lose value in absolute terms. While your percentage share will decrease, the increase in the company's total value may offset this reduction in terms of financial value.

Dilution protection

In the context of an investment in a startup or growing company, investors can negotiate and establish dilution protection clauses, with the purpose of protecting their interests and safeguarding their investment against the effects of capital increases on disadvantageous terms. What are they?

  • Right of First Refusal (ROFR): This clause gives existing investors the right to purchase new issued shares before they are offered to outside third parties. If the company plans to issue new shares, current investors have the opportunity to maintain or increase their holding before they are diluted.
  • Proportional Purchase Right (PRORATA): The right to buy in proportion to their current ownership ensures that existing investors have the option of buying new shares in proportion to their current ownership. This helps to maintain your ownership percentage and avoid excessive dilution.
  • Weighted Average Anti-Dilution Clause: This clause adjusts the price at which the previous shares were issued in the event of a new issue at a lower price. The adjustment is made based on the number of new shares issued and their price. This protects existing investors from significant dilution if the value of the shares decreases.
  • Full Action Clause (Full Ratchet Anti-Dilution): This clause adjusts the price at which the previous shares are issued to match the lower price of the new shares issued. This protects existing investors from any dilution, even if the price of the new shares is much lower than the original price.
  • Profit Sharing Clause (Participation Rights): This clause gives investors the right to receive dividends or distributions before other shareholders receive payments, which can help offset the dilution in terms of earnings. This right is commonly implemented within preferential settlement clauses. When this clause is “participatory”, it implies that in the case of a “liquidity event”, the investor is first distributed the money he put into the capital increase in which he entered the company, and then the pro rata of the difference is distributed to him.
  • Automatic Conversion and Adjustment Clauses: These clauses establish conditions under which preferred shares can be converted into common shares under certain circumstances. This can influence ownership structure and dilution.

Importantly, dilution protection clauses can have implications for both existing investors and the company as a whole. These clauses must be carefully negotiated to balance the interests of investors with the company's growth and funding needs. Dilution protection clauses can influence investment dynamics and strategic decisions in the future. As we have seen throughout the article, dilution is a crucial component in business financing that deserves meticulous attention from entrepreneurs and business leaders. It's essential for leaders to deeply understand the pros and cons of dilution when planning their growth strategy and seeking funding.

Pros of dilution

  • Funding for growth: Dilution can provide the capital needed to drive growth, finance new initiatives and seize strategic opportunities.
  • Additional resources: In addition to financial capital, new investors can provide non-financial resources, such as technical knowledge, and strategic guidance, as well as contacts and advice that can accelerate company development.
  • Risk Mitigation: By diversifying the investor base, the startup can distribute financial risks and reduce dependence on a single source of funding.
  • External validation: Attracting outside investors can be a sign of validation for the market and potential partners, increasing the credibility and reputation of the startup.

Cons of dilution

  • Dilution of property: Each issue of new shares reduces the percentage ownership of the original shareholders, which can dilute their influence and participation in the company.
  • Control dilution: As new investors acquire ownership, the company's decision-making and management may be affected.
  • Lower participation and benefits: Dilution reduces ownership and potential benefits for original shareholders, which can affect motivation and incentive alignment.
  • Challenging assessment: Each round of funding involves a valuation of the company, which can be a challenge in terms of negotiating and determining fair value.
  • Complex communication: Managing expectations and communicating the effects of dilution to existing investors can be complicated and require transparent communication.
  • Investment conditions: Some investors may impose conditions and clauses that limit the startup's flexibility and autonomy in the future.
  • Pressure for results: Additional investment can lead to expectations of faster growth and stronger results, which could increase pressure on the startup.

It's important to recognize that raising capital is a valuable funding tool, but it also has significant implications in terms of ownership, control and direction. Startups should carefully evaluate the pros and cons that the resulting dilution may entail, and consider how they align with their growth objectives and long-term vision.