Dilution

What does dilution mean?

Dilution (also known as share dilution) is the fall in a shareholder's ownership percentage, that is, their percentage share of the company. It occurs when the company issues new shares or rights to shares and the shareholder does not take part pro rata. This must be distinguished from economic dilution: the fall in the value attributable to a single share. The percentage falls in almost every funding round; the value falls mainly when new shares are issued below the existing value per share.

The difference is easily illustrated by a cake that is shared among more people: each slice becomes smaller. If the newcomers bring enough cake themselves, however, the smaller slice of a larger cake can contain more than the larger slice did before.

Dilution is the regular consequence of any equity financing. In a GmbH (German limited liability company), it arises legally through a capital increase, which creates new shares (Geschäftsanteile). Virtual employee programmes (promises to employees that they will share in the sale proceeds like shareholders) and conversion rights (rights to convert a loan into shares later) do not initially change the list of shareholders. They do, however, reduce the shareholders' share of future proceeds. Both become visible in the cap table, the overview of all participants and their shares. In every funding round and in the distribution of proceeds in a company sale, dilution determines what the existing shareholders are left with.

Calculating dilution: ownership percentage and value

The ownership percentage measures what part of the company belongs to a shareholder. In a GmbH, it results from the ratio of the nominal amounts of the shareholder's shares to the share capital (Stammkapital). The nominal amount is the euro amount on which a share is denominated, usually EUR 1; the share capital is the sum of all nominal amounts. As against the company, the shareholder list entered in the commercial register (Handelsregister) applies. For funding rounds, the parties additionally calculate with the fully diluted percentage (Fully Diluted). It also counts virtual shares, the employee pool and conversion rights as though they had already become shares.

Formula: Dilution = new shares / (existing shares + new shares)

Every existing percentage is multiplied by the factor 1 minus dilution. If 20,000 new shares are added to 80,000 shares, dilution is 20%, and a holding of 50% becomes 50% × 0.8 = 40%. That is ten percentage points, but a dilution of 20%. Over several rounds the factors multiply. After three rounds of 20% dilution each, 0.8 × 0.8 × 0.8 = 51.2% of the original percentage remains.

The value of a shareholding does not follow the percentage alone, because the price of the new shares flows to the company. The existing shareholders then hold a smaller share of a company that is wealthier by that amount. A founder holds 50% of a company that is worth EUR 10 million before the round. If EUR 2.5 million flows in at the same value per share, she then holds 40% of EUR 12.5 million. Her stake is worth EUR 5 million both before and after.

If the new shares are issued at least at the existing value per share, the value of the existing shares is therefore preserved or rises. It falls if new shares are issued below that value or if third parties receive share rights without paying in capital, for example employees from a pool.

Voting rights and thresholds

With the percentage, the voting weight of genuine shares falls too, because under Section 47(2) of the German Limited Liability Companies Act (GmbHG) each euro of nominal amount carries one vote. Ordinary resolutions require a majority of the votes cast; amendments to the articles of association, including capital increases, require three quarters (Section 53 GmbHG). A shareholder who holds more than 25% of the votes can block such amendments (blocking minority). Investors' consent rights in the shareholders' agreement, by contrast, apply regardless of the percentage.

Causes of dilution

Capital increase in the funding round

The most common case is the capital increase against a cash contribution. The shareholders resolve the increase in share capital in notarised form. The investors take the new shares at their nominal amount and pay the part of the price above that as a premium into the capital reserve (Kapitalrücklage), a separate item of equity. A shareholder who exercises their subscription right (Pre-emptive Rights), that is, takes new shares in proportion to their existing percentage, keeps their percentage. To do so, however, they must invest at the price of the round.

Employee participation

A virtual participation programme (VSOP, Virtual Stock Option Plan) creates no shares. The percentages shown in the shareholder list remain unchanged, but the employees receive payment entitlements that are measured by the proceeds per share. Economically, the pool, meaning the totality of the virtual shares reserved for employees, acts like additional shares. If it is created before a round and included in the pre-money valuation (the valuation before the new capital flows in), the existing shareholders bear this dilution alone. If it is created only after the round, it is spread across all shareholders, including the new investors.

Conversion rights and anti-dilution protection

A convertible loan usually converts into shares in the next funding round. The conversion price lies below the round price because of a discount or a valuation cap. The number of conversion shares is therefore only fixed once the round price is known. Option rights that providers of growth loans (venture debt) have granted to them in addition to interest work in a similar way. A further source is the anti-dilution protection of earlier investors (Anti-Dilution Protection). If a round takes place at a lower price per share, the protected investors receive compensation shares, which dilute all unprotected shareholders further.

Dilution with rising and falling valuations

In a round at a higher price per share (up round), the percentage falls while the notional value of the existing shares rises. Whether giving up the stake was worthwhile only becomes clear at the exit, that is, on the sale of the company or an IPO. It was worthwhile if the smaller stake then yields more than the larger stake would have yielded without the new capital.

In a round at a lower price per share (Down Round), the percentage and the value fall at the same time. More new shares are needed for the same amount, and compensation shares from an anti-dilution protection are added. Whether a down round has occurred is decided by the price per share, not by the stated valuation.

The percentage also describes the share of the proceeds only as long as no preferential rights apply. If investors receive a fixed amount first when sale proceeds are low (Liquidation Preference), the founders' economic share in that range is clearly below their percentage.

Worked example: dilution over two funding rounds

Two founders together hold 52,000 shares with a nominal amount of EUR 1 each. In the Series A, an investor invests EUR 5 million; the pre-money valuation on a fully diluted basis is EUR 15 million. The investor requires a virtual pool of 10% after the round, which the pre-money valuation already includes. The investor also receives anti-dilution protection on a broad-based weighted average basis (Weighted Average).

• Series A: post-money valuation 15 + 5 = EUR 20 million; investor's percentage 5 / 20 = 25%; founders' percentage 100% minus 25% minus 10% = 65%
• Total shares: 52,000 / 0.65 = 80,000, of which 8,000 virtual shares in the pool and 20,000 new shares of the investor
• Price per share: EUR 15 million / (52,000 + 8,000) = EUR 250; value of the founders' shares at the round price 52,000 × EUR 250 = EUR 13 million
• Series B at a rising price: EUR 8 million at a pre-money valuation of EUR 32 million, so EUR 32 million / 80,000 = EUR 400 per share and EUR 8 million / EUR 400 = 20,000 new shares
• Series B at a falling price: EUR 3 million at a pre-money valuation of EUR 12 million, so EUR 12 million / 80,000 = EUR 150 per share and likewise 20,000 new shares
• Founders' fully diluted percentage in both cases: 52,000 / 100,000 = 52%, a fall of 13 percentage points or 20%
• Value of the founders' shares at the round price: with a rising price 52,000 × EUR 400 = EUR 20.8 million, with a falling price 52,000 × EUR 150 = EUR 7.8 million
• Anti-dilution protection in the second case: under the broad-based weighted average, the relevant price of the Series A investor falls to 250 × (80,000 + 12,000) / (80,000 + 20,000) = EUR 230. The 12,000 are the shares that EUR 3 million would have bought at the old price of EUR 250.
• Compensation: EUR 5 million / EUR 230 = 21,739 shares (rounded down), so 1,739 additional shares that the Series A investor takes at the nominal amount; the founders' percentage falls to 52,000 / 101,739 = about 51.11%

Both cases of the Series B dilute the founders equally strongly in arithmetic terms. The difference lies in the value: with a rising price the value of their stake grows by 60%, with a falling price it falls by 40%. In the second case, the anti-dilution protection of the Series A investor reduces their percentage further.

Distinctions: dilution, fully diluted and anti-dilution protection

• Fully Diluted: the calculation basis that includes all share rights in addition to the shares. Dilution describes the change in a percentage; fully diluted is the basis on which it is measured.
• Anti-Dilution Protection: protects individual investors not against the dilution of their percentage but against a lower issue price in a later round. The protection shifts the dilution onto the remaining shareholders.
• Subscription right: the right to take part in a capital increase in proportion to the existing percentage. It prevents the dilution of the percentage but requires own capital.
• Cramdown: a financing at a very low price that dilutes shareholders who do not invest alongside particularly heavily.

Common mistakes

• Equating percentage and value. A falling percentage does not mean that the stake is worth less. What matters is the price per share at which the new shares are issued.
• Looking only at the shareholder list. Virtual shares, option rights and conversion rights do not appear there but reduce the share of the proceeds. Only the fully diluted percentage is reliable.
• Underestimating convertible loans. With a low valuation cap, a loan converts into significantly more shares than its amount would yield at the round price. The conversion belongs in the planning for several round prices.
• Treating the pool as a side issue. A pool included in the pre-money valuation lowers the price per share and thus the value of the existing shares. Pool size and timing belong in the same negotiation as the valuation.
• No calculation for falling prices. The anti-dilution protection of earlier investors only works in a down round and is therefore often missing from the planning. Without this calculation, it remains open what percentage the founders are left with in the unfavourable case.

Frequently asked questions

Does every funding round dilute the existing shareholders?

In percentage, yes, unless they take part in the round in proportion to their holding. In value, not necessarily: with a rising price per share it grows despite the falling percentage, in the worked example by 60%, and with a falling price it falls.

Can founders protect themselves against dilution?

Against the dilution of the percentage only by taking part in capital increases pro rata, for which they usually lack the funds. Protection against lower issue prices is generally granted only to investors. Founders rather secure their influence through voting agreements and nomination rights for an advisory board.

How is dilution calculated in a funding round?

New shares divided by the total number of shares after the round. Without a new pool and without conversions, this equals the investment amount divided by the post-money valuation. If an investor invests EUR 5 million at a post-money valuation of EUR 20 million, dilution is 25%. A holding of 40% then falls to 30%.

How much dilution is usual in a funding round?

As a rule of thumb, existing shareholders often give up 15 to 25% in Series A to Series C rounds, plus, where applicable, a new or enlarged employee pool. There is no fixed upper limit. How much is given up follows from the capital requirement and the valuation.

The Roemer Capital view

Roemer Capital does not look at dilution round by round but as a path to the planned exit. In the financial model built for a funding round, the percentage and value of the founders' stake are carried forward across all planned rounds, in each case in the base case, the cautious case and the optimistic case. This shows what share actually remains after the pool, conversions and possible compensation shares.

Investor offers are compared by the price per share on the same fully diluted basis and by the share that remains with the existing shareholders afterwards. The legal implementation of the capital increase lies with the company's law firm. Roemer Capital's contribution is the figures on which the shareholders base their decision.