Understanding Equity Dilution

Equity dilution is defined as the decrease in equity ownership for existing shareholders that occurs when a company issues new shares. Typically, a founder starts out owning 100% of a company and, every time capital is raised or shares are issued, that ownership stake is reduced. This is why equity dilution is sometimes called founder dilution. It is also known as stock dilution, share dilution, private company dilution and startup dilution.

To understand how dilution works in practice, consider this example. Let’s say the founder of a company valued at $2 million owns 100 shares, representing a 100% ownership stake. To finance growth, the company raises an additional $500,000 and issues 25 new shares to its new investor, increasing the total pool of shares to 125. Despite still owning 100 shares, the founder’s ownership stake drops to 80% (100 out of 125), while the new investor now owns 20% of the company (25 out of 125). After enough equity dilution takes place, the founder’s stake may be reduced to less than 50%, risking the loss of majority voting power.

However, while the founder’s ownership stake has declined, the total post-money valuation of the company is now $2.5 million—meaning the founder’s 80% stake is still worth $2 million. That’s why founders and early investors may be willing to accept some measure of equity dilution as long as the valuation of the company rises.

A challenge arises if, due to market conditions or underperformance, the valuation of the company declines. In this case—or if a founder is at risk of losing ownership control—some founders and early investors may seek protection through anti-dilution measures.

While the most common source of equity dilution is fundraising, there are several other scenarios where equity may get diluted. For instance, if employees are awarded restricted stock units (RSUs) as part of their equity compensation, existing shareholders will see their equity diluted when those RSUs vest. Similarly, if a company issues convertible debt, current shareholders will be diluted if those notes are converted into new shares. The same is true if stock option holders exercise their options and become shareholders. 

A basic formula for calculating equity dilution is to divide a current shareholder’s total number of existing shares by the sum of the total number of outstanding shares + the total number of new shares, as shown in the example above.

In practice, however, multiple factors go into the calculation of equity dilution, such as:

• New shares from equity investment
• Shifts in company valuation
• Conversions of convertible notes with warrants, valuation caps, and/or discounts
• Issuance of new options before and/or after the fundraising round
• Repurchase of stock as part of the new round

Given these complexities, some companies may rely on equity administration software to help model various fundraising scenarios and calculate dilution. Find out how Morgan Stanley at Work can help you calculate share dilution so that you can maintain an accurate cap table. 

Fully diluted equity refers to a company’s ownership picture assuming all potential shares become actual shares. In other words, it includes not only shares currently outstanding, but also shares that could be issued if equity-linked instruments are exercised, vested, or converted—such as:

• Stock options (assumed exercised)
• RSUs (assumed vested/settled into shares)
• Warrants (assumed exercised)
• Convertible notes and SAFEs (assumed converted into equity, if applicable)
• Unissued but reserved shares in an equity plan pool (depending on the specific definition being used)

The goal is to show a more complete view of “true” ownership percentages once potential dilution is considered.

Diluted equity value generally describes the value of a stakeholder’s ownership after accounting for dilution from all other current and potential shares (i.e., on a fully diluted basis), rather than looking only at currently outstanding common shares.

In practice, people use the term in two closely related ways:

• Diluted ownership percentage: your percentage of the company on a fully diluted basis; and/or
• Diluted value of your stake: an estimate of what your holdings may be worth when your ownership is measured against the fully diluted share count (often tied to an assumed company valuation or exit outcome).

Because it depends on assumptions (conversion terms, vesting, exercise, timing, and valuation), “diluted equity value” is best treated as an estimate, not a guaranteed outcome.

Not necessarily. Dilution reduces your percentage ownership, but it does not automatically reduce the economic value of your stake.

A simplified example:

• If you own 1% of a company worth $100M, your stake is notionally $1M.
• If new shares are issued and you are diluted to 0.7%, but the company grows and is now worth $200M, your stake is notionally $1.4M.

Dilution can be value-negative when new capital is raised or shares are issued without a commensurate increase in company value, or when the financing terms shift economics materially. But dilution is often associated with fundraising that aims to accelerate growth—so the net impact depends on execution and valuation outcomes.

Anti-dilution protection can help protect from dilution when shares are sold at a price per share that is less than the price paid by earlier investors. Also known as subscription privileges, subscription rights and pre-emptive rights, there are two common types of anti-dilution provisions:

• Full rachet anti-dilution measures allow investors to maintain nearly the same ownership stake as before the company’s valuation declined, compensating for any dilution caused by future fundraising rounds.

• Weighted average anti-dilution measures determine the rate of dilution based on the amount of money and price per share previously raised compared to the amount of money and price per share raised during future financing rounds. While they do not eliminate dilution, they reduce the rate of dilution that would otherwise occur.

Options and RSUs contribute to dilution by increasing the number of shares that can become outstanding:

• Stock options: Dilution occurs when options are exercised and new shares are issued (or when shares are reallocated from treasury/repurchased shares, depending on the structure). Even before exercise, many cap tables and investors include options in fully diluted counts because they represent potential future shares.
• RSUs: Dilution typically occurs as RSUs vest and settle into shares. Like options, RSUs are commonly included in fully diluted calculations even prior to settlement, depending on the context and definition.

Also note: expanding the equity incentive pool (e.g., increasing the option pool) can be dilutive as well, because it increases the number of shares reserved for future grants.

Convertible notes and SAFEs generally affect dilution when they convert into equity, usually in connection with a future financing round (or another defined conversion event). The number of shares issued on conversion—and therefore the amount of dilution—often depends on conversion terms such as:

• Valuation caps: A cap can allow conversion at a more favorable price than the new round, typically resulting in more shares issued to the note/SAFE holder (more dilution to existing shareholders than if conversion were at the round price).
• Discounts: A discount (e.g., converting at 80–90% of the round price) similarly increases the shares issued upon conversion relative to converting at the round price.
• Accrued interest (convertible notes): Notes may convert principal plus interest, which can increase the conversion amount and resulting share count.
• Most favored nation (MFN) or other provisions: Certain terms can adjust economics and affect resulting dilution.

Because the dilution impact depends on future financing details (price, pre-money, size of round, pool increases, and conversion mechanics), it’s often modeled using scenarios rather than a single point estimate.