Understanding Stock Dilution -- and Why You Should Care About It
View Original ArticleFri, 16 Jan 2015 05:52:30 -0800 Understanding Stock Dilution -- and Why You Should Care About It
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How to Calculate Stock Dilution
Stock dilution occurs when a company decides to raise capital by issuing more stock to new investors. When the "float" (the amount of shares outstanding) is increased, the investors who already own shares now have a smaller percentage of shares. Stock dilution usually occurs during a company's start-up or venture capital raising phase.
1. How does your company divide up its initial stock? When your stock-issuing company is formed, there is a certain amount of shares that belong to the company. Those shares are then divided up among the principals of the company, such as the board of directors, chief operating officer and chief financial officer. For example, a company has 2 million shares of stock when it is formed and a board member is offered 5 percent, or 100,000 shares, during the "pre-funding period."
2. What is the value of your company? As you get the company off the ground, there is essentially no value or assets. Therefore the value is essentially 0. This is also called net-tangible book value.
3. What happens when investors purchase shares in your company? They are going to offer you an amount of money for a percentage ownership in your company. Furthering the example above, say investors are willing to stake $2 million for 50 percent of the company. This immediately gives the company a value. To calculate the value, perform a simple algebra equation.
Investment / Percent Ownership = New Value $2,000,000 / .50 = $4,000,000
In this equation 50 percent is changed to decimal form to calculate the equation. The equation essentially states if 50 percent of the company is worth $2 million, then 100 percent of the company must be worth $4 million. This is referred to as the "post-money valuation."
4. How many more shares need to be added to the float based on the post-money valuation? Because you cannot take shares away from people who already have them, you must create new shares. To calculate exactly how many shares you need to add, you need this algebra equation:
x / (Original Shares Issued + x) = Percent Ownership "x" represents the number of new shares that must be added. x / 2,000,000 + x = .50 2,000,000 / (2,000,000 + 2,000,000) = .50
This means the company would need to add 2 million shares to the float to meet the new ownership demand.
5. Calculate how the new float dilutes the shares that you currently own. Using the example above, the investor was offered 5 percent of the original float, which was 100,000 shares based on 2 million original shares. He now holds 100,000 shares out of 4 million. The equation becomes:
This is just a simple illustration on how share dilution effects current and new stockholders in your company.