When a company carries out a capital increase (issuing new shares that are added to existing ones), investors who buy these new shares acquire a portion of the company's ownership. This has a direct effect on the ownership percentage of the original shareholders, which is reduced as a result of the increase in the total number of outstanding shares.

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In other words, dilution represents a "reduction" in the ownership percentage for existing shareholders, as their stake is divided among a larger number of shares after the capital increase. It is very important to note that this does not necessarily imply a reduction in the total "value" of their shares. While dilution can be a natural consequence of a company seeking funding and growth, it is important for existing shareholders to understand its impact on their voting rights, decision-making, and the overall value of their investment.

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

• Funding for growth: One of the most common reasons for a capital increase is to obtain the necessary funds to expand operations and increase market presence. These funds can be used to boost production, enter new markets, launch new products or services, and/or strengthen the customer base.
• Investment in new projects: Companies may undertake a capital increase to fund the research and 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. A capital increase can provide the necessary resources to recruit 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 obtained can be used to purchase 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 reduce 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 demand a capital increase. This could be necessary to maintain licenses, meet minimum capitalization standards, or other regulations.- Strategic opportunities: Companies can seize strategic opportunities, such as investments in promising startups or joint ventures with other market players. A capital increase can provide the resources to capitalize on these opportunities.

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As we can see, a capital increase 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.

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Causes and effects of dilution

Dilution affects both the ownership stake and voting rights of a company's original shareholders. But why? Before new shares are issued, original shareholders own a specific stake in the company, expressed as a percentage of the total shares outstanding. However, as we've already mentioned, when new shares are issued and sold to new investors, the total share base increases. This means that the original shareholders' stake, expressed as a percentage, is automatically reduced. Although their number of shares may remain the same, their ownership relative to the total decreases. And, since shareholders typically have voting rights proportional to their ownership in the company, when their percentage of ownership is diluted, their influence on decision-making also decreases. Therefore, The more shares they own relative to the total, the greater their influence on corporate decisions through voting. This can be particularly relevant in important situations, such as the election of the board of directors, the approval of significant strategic changes, or decisions requiring shareholder approval.

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‍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 shares outstanding increase to 1,500. In this scenario, if the investor does not participate in the share issuance, they will retain their 100 shares, but their ownership will be reduced to 6.67% (100/1,500), directly impacting their influence on decisions and voting rights. This phenomenon must be carefully considered when making decisions related to a company's financing and growth.

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Dilution Formula

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

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Simple Dilution Example:

‍If a startup has 1,000 shares outstanding and issues 500 new shares for financing, after the issuance, the total shares outstanding will be 1,500. Therefore, 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 original shareholder's ownership is diluted by 33.33% due to the issuance of new shares, leaving their ownership at 6.67%. On the other hand, fully diluted ownership considers not only issued common shares but also the effect of all convertible securities (such as options and convertible bonds) that could increase the number of outstanding shares in the future.

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The formula for calculating Full Dilution is as follows:

Example of Full Dilution:

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

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‍Additional Considerations

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

As we mentioned at the beginning of the article, it's important to note that full dilution does not necessarily mean that current investors lose absolute value. While their percentage ownership will decrease, the increase in the company's total value can offset this reduction in financial terms.

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Anti-Dilution Protection

In the context of investing in a startup or growth company, investors can negotiate and establish anti-dilution clauses, to protect their interests and safeguard their investment against the effects of capital increases on unfavorable terms. What are they?

• Right of First Refusal (ROFR): This clause grants existing investors the right to purchase newly issued shares before they are offered to external third parties. If the company plans to issue new shares, current investors have the opportunity to maintain or increase their stake before it is diluted.‍
• Pro-Rata Purchase Right (PRORATA): The pro-rata purchase right ensures that existing investors have the option to purchase new shares in proportion to their current ownership. This helps maintain their ownership percentage and prevent excessive dilution.‍
• Weighted Average Anti-Dilution Clause (Weighted Average Anti-Dilution): This clause adjusts the price at which previous shares were issued in the event of a new issuance 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 share value decreases.‍
• Full Ratchet Anti-Dilution Clause (Full Ratchet Anti-Dilution): This clause adjusts the price at which previous shares were issued to match the lowest price of the newly issued shares. This protects existing investors from any dilution, even if the price of the new shares is much lower than the original price.‍
• Participation Rights Clause (Participation Rights): This clause grants investors the right to receive dividends or distributions before other shareholders receive payments, which can help offset dilution in terms of earnings. This right is commonly implemented within preferred liquidation clauses. When such a clause is “participating,” it means that in the event of a “liquidity event,” the investor first receives the money they invested in the company's capital increase, and then receives a pro-rata distribution of the remaining difference.‍
• Automatic Conversion and Adjustment Clauses (Automatic Conversion and Adjustment): These clauses establish conditions under which preferred shares can be converted into common shares in certain circumstances. This can influence ownership structure and dilution.

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It is important to note that anti-dilution 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. Anti-dilution clauses can influence investment dynamics and future strategic decisions. As we have seen throughout this article, dilution is a crucial component in business financing that requires meticulous attention from entrepreneurs and business leaders. It is essential for leaders to deeply understand the pros and cons of dilution when planning their growth strategy and seeking funding.

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Pros of Dilution

• Funding for Growth: Dilution can provide the necessary capital to drive growth, fund new initiatives, and seize strategic opportunities.‍
• Additional Resources: Beyond financial capital, new investors can provide non-financial resources such as technical expertise and strategic guidance, as well as connections and advice that can accelerate the company's development.
• ‍ Risk Mitigation: By diversifying its investor base, a startup can distribute financial risks and reduce reliance on a single funding source.‍
• External Validation: Attracting external investors can signal validation to the market and potential partners, enhancing the startup's credibility and reputation.

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Cons of Dilution

• Ownership Dilution: Each issuance of new shares reduces the percentage ownership of original shareholders, which can dilute their influence and stake in the company.‍
• Control Dilution: As new investors acquire a stake, the company's decision-making and direction could be affected.‍
• Reduced Stake and Returns: Dilution reduces ownership and potential returns for original shareholders, which can impact motivation and incentive alignment.‍
• Challenging Valuation: Each funding round involves a company valuation, which can be challenging in terms of negotiation and determining fair value.‍
• Complex Communication: Managing expectations and communicating the effects of dilution to existing investors can be complicated and requires transparent communication.‍
• Investment Conditions: Some investors may impose conditions and clauses that limit the startup's future flexibility and autonomy.
• ‍Pressure for Results: Additional investment can create expectations for faster growth and stronger results, which could increase pressure on the startup.

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It's important to recognize that capital increases are a valuable financing tool, but they also carry significant implications in terms of ownership, control, and direction. Startups must carefully evaluate the pros and cons of the resulting dilution and consider how it aligns with their growth objectives and long-term vision.

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Most Common Mistakes When Raising Capital

1. Failing to calculate cumulative dilution. Articles discuss individual rounds, but the reality is between four and six rounds until exit, with compound dilution that can reach 70-80% of the original equity.

2. Accumulating SAFEs without control. Cap tables with fifteen or twenty small-ticket SAFEs that explode at Series A. Our criterion: use them only if unavoidable, with a limit of €300,000-€500,000 before an equity round, and always with an MFN (Most Favored Nation) clause.

3. Dead equity. Advisors with 0.5-1% without real vesting, or employees who left early taking already vested equity without having contributed long-term. This can block a funding round if the "dead" percentage is high.

4. Inflated valuation. Raising a seed round at a very high pre-money valuation without real traction isn't ambition, it's a risk: it leaves you with no options when Series A doesn't validate that figure and you have to lower the price.

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Unit Economics: the best lever to dilute less

The best way to negotiate a high valuation, and thus dilute less, is to demonstrate that your business model has measurable efficiency: gross margin, CAC, LTV, Payback Period, and Burn Multiple. A founder who comes to a seed round with a gross margin above 70% and a CAC Payback period of less than twelve months isn't asking the investor for a favor; they're offering an asset with proven efficiency.

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We explain how to build and present these metrics effectively in our article on financial metrics for startups: https://www.intelectium.com/es/post/metricas

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When is it a mistake to accept a low valuation due to cash urgency?

Almost always, but with a nuance. In Spain, instruments like ENISA or ICO Directo have resolution periods of three to six months, and there isn't an accessible secondary equity market for early-stage startups. With less than three months of runway, negotiation power is non-existent.

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The solution isn't to bravely negotiate from that position. It's to avoid getting into that position: raising with nine to twelve months of runway in the bank turns negotiations into a conversation between equals.

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Frequently Asked Questions

What percentage of dilution is acceptable in a seed round?

Between 15% and 20% is the target range in the Spanish context. Giving up more than 25% compromises your room for maneuver in subsequent rounds and can cause you to lose strategic control before Series B.

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Are SAFEs a good tool to avoid dilution in early stages?

They are fast, but not free. A SAFE with a low cap and a 20% discount can lead to a real dilution of 30-40% upon conversion. Only use them if they are unavoidable, limit the total to €300,000-€500,000, and always negotiate an MFN clause.

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How does the option pool affect my dilution as a founder?

If the investor demands that the pool be calculated post-money, the dilution falls entirely on you. A 15% post-money pool can result in more than 20% additional dilution. Always negotiate a pre-money pool.

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What metrics do I need to better negotiate valuation and reduce my dilution?

A gross margin above 70%, CAC Payback under twelve months, and a Burn Multiple below 1.5x are the indicators that Series A investors in Spain most frequently demand.

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When do founders lose effective control due to accumulated dilution?

The critical threshold is around 40% combined founder equity. Below that, without contractual vetoes or a board majority, strategic decisions can be made without your consent.

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Protecting your stake in each round begins before negotiating the term sheet: in the structure of instruments you accept today. At Intelectium, we help you model your cap table and define your dilution budget before you go out to raise capital. Contact us: dealflow@intelectium.com