In the dynamic environment of startups, the process of introducing new shareholders can often lead to unintended consequences. Typically, shares in a startup are issued through several mechanisms:
- as part of the initial structure;
- to investors in exchange for capital (ie, a monetary investment);
- via convertible instruments like SAFEs or convertible notes; and
- to employees through an Employee Share Scheme (more commonly known as ESOPs).
- An essential aspect to understand in all these scenarios is the concept of share dilution.
Dilution occurs when a company issues new shares, reducing the ownership percentage of existing shareholders. While dilution can decrease individual shareholders’ control and earnings per share, it often accompanies valuable company growth and investment opportunities. Understanding how dilution works in different scenarios is crucial for startups to navigate their growth successfully.
Initial Share Structure and Dilution
It is important to remember that if you have agreed equity splits with co-founders already in place at the time you set up your company, the new company shareholding should reflect these arrangements. It will be far more convenient for all original founders to have their shareholding in place from day 1, and this initial share structure sets the baseline from which future dilution will occur through subsequent share issuances.
It’s important to note that in Australia, companies cannot hold shares in themselves, meaning there’s no concept of reserving or setting aside shares at this stage. Therefore, when you set up, the original shareholders should all own that number of shares that reflects the intended holding. Getting your company structure and founder equity splits properly documented from day one – ideally in a shareholders’ agreement – makes it far easier to manage dilution as you grow.
Equity Investment and Shareholder Dilution
As stated above, shares cannot be set aside for future allocation. Therefore, when a company brings on an equity investor, it (generally) issues new shares to investors, which increases the total number of shares. You may have had 1,000 shares between 4 founders when you set up, then you issue 100 to a shareholder. This results in 1,100 shares on issue, thereby diluting existing ownership percentages.
When introducing new investors, other than where an existing shareholder is seeking to exit the company, it is generally preferable to issue new shares (ie, rather than transfer them). Transferring shares can lead to unintended consequences such as:
- You will likely trigger capital gains tax consequences because you are disposing of an asset.
- Further, the investment proceeds are paid to you personally rather than to the company.
- From a dilution perspective, only your ownership interest will be diluted, whereas an equity investment should generally dilute all shareholders equally.
While dilution reduces your ownership percentage, investment should increase the company’s overall value. As a result, a smaller ownership stake may still become more valuable over time.
Most startups raise capital multiple times throughout their journey. For that reason, founders should think carefully about dilution in the early rounds. You do not want to dilute yourself too heavily, too early, and end up as a minor shareholder before completing your funding rounds.
If you are preparing for a new investment round, our venture capital and investing lawyers can help you structure the raise and protect your position. You can also read our guide to managing your cap table, which explains how to track ownership across multiple funding rounds.
SAFEs and Convertible Notes
Under SAFEs and convertible notes, investors pay upfront but receive shares later, typically during a larger equity investment round. One of the benefits of these types of instruments is that they delay the need for a company valuation, as the investment converts based on the valuation at the triggering event.
Founders must account for the shares that SAFEs and convertible notes will issue during the triggering equity investment round to avoid unexpected dilution.
New investors typically want protection from dilution caused by outstanding SAFEs, so companies usually factor those future shares into the calculation.
We have heard stories (likely cautionary tales, but pertinent nonetheless) about founders who diluted themselves out of their own companies.
Our friends at CAKE have helpful dilution modelling tools which founders can use to calculate their dilution, taking convertible instruments into account when they do so.
ESOPs and Employee Share Options
Under employee share schemes, employees are generally either issued shares or options. Direct share issuance to employees causes immediate dilution, so understanding dilution is fairly straightforward.
When options are issued, the employee is granted a right to be issued shares at a future time. As mentioned above, there is no reserving shares in Australia. Therefore, the concept of an option pool is something which only exists on paper. Like convertible instruments, outstanding options can also affect dilution calculations. Investors typically expect companies to account for any outstanding options when calculating the number of shares issued in an investment round. This approach ensures investors do not face dilution when option holders later exercise those options.
Frequently Asked Questions
1. What is shareholder dilution?
Shareholder dilution occurs when a company issues new shares, reducing each existing shareholder’s percentage ownership.
It typically happens when a startup brings on new equity investors, converts SAFEs or convertible notes into shares, or issues shares or options under an Employee Share Scheme (ESOP).
2. Does raising investment always dilute existing shareholders?
Generally, yes. When a startup issues new shares to an investor – rather than an existing shareholder transferring their own shares – the total number of shares on issue increases, so existing holders’ percentage ownership goes down proportionally. That said, the value of the company, and often each shareholder’s stake, can still grow as a result of the investment.
3. How do SAFEs and convertible notes affect dilution?
Investors under a SAFE or convertible note pay upfront but don’t receive shares immediately. Dilution is delayed until a later triggering event – usually the next priced equity round – at which point the instrument converts into shares based on that round’s valuation. This means founders often don’t feel the full dilution impact until conversion happens.
4. Does setting up an Employee Share Scheme (ESOP) dilute shareholders?
It depends on the structure. Directly issuing shares to employees causes immediate dilution.Issuing options works differently. Dilution does not occur until an employee or holder exercises the option. However, investors typically expect companies to account for any outstanding option pool before they invest.
5. Can shareholder dilution be avoided or minimised?
While founders usually cannot avoid dilution entirely when raising capital or using equity to attract talent, they can manage it effectively.
Founders should maintain a clear cap table, understand how SAFEs and option pools will convert in advance, and make deliberate decisions about the timing and size of funding rounds.
Key Takeaways on Managing Shareholder Dilution
Navigating shareholder dilution is a critical aspect of managing a startup. Understanding how each method of share issuance affects ownership and control is essential for making informed decisions. Whether through initial setup, equity investments, SAFEs and convertible notes, or ESOPs, the key lies in striking a balance between necessary dilution for growth and maintaining significant control and value in the company. Awareness and strategic planning can ensure that dilution is a tool for growth, rather than an unintended setback.
Our team of commercial law experts at Allied Legal can help, as we have a wealth of experience with structuring equity and assisting with issues around dilution. You can connect with one of our commercial law experts by giving us a call on (03) 8691 3111 or emailing us at hello@alliedlegal.com.au
Related reading: Pro-Rata Rights in Australian Equity Offerings · Founder Vesting Arrangements Explained · Restricted Shares vs Options: Australian Startups Guide
This article is provided for general information only and does not constitute legal advice. You should obtain legal advice specific to your circumstances before acting on any information contained in this article.
