By Fernando Berrocal

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The value of current stock is partially decreased when a business approves new stock. This common occurrence is known as "stock dilution" (or "share dilution"). Here is a simple example that explains why stock dilution occurs.

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Assume you're a sole founder. Having complete control of the business, you've authorized and acquired 100 shares; and you want to entice candidates to join by granting stock options. So, you authorize 25 more shares and distribute them to your employees. There are currently 125 shares (again, 100 of which belong to you). Before issuing the shares, you owned 100%; now you possess four-fifths (80%). Employees own 20% of your business. This is stock dilution at a basic level: By introducing shares, you've "diluted" your ownership interest.

In real life, the possibility of stock dilution occurring at this level is minimal. Most entrepreneurs issue a minimum of one million shares, and each of those shares is often worth a fraction of a cent of a dollar. 

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What events at your startup are likely to trigger stock dilution? In a startup, stock dilution generally is caused by one of the following situations:

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1. Your organization's stock option pool (SOP) increases. Your term sheet will define how many extra shares you must authorize as compensation for future workers.

2. As part of a pricing round, your business approves to have more shares. To raise funds, these shares are issued in return for money from investors.

3. SAFEs or convertible notes convert (also as part of a pricing round). When a pricing round occurs, you'll need to authorize shares, which you'll distribute to the noteholders. The number of shares each note holder gets is determined by the amount they invested and the SAFE's valuate cap.

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Even when shares are diluted, their value generally rises: While it comes to maintaining your ownership interest (the amount of influence you have as a founder,) it's critical to consider dilution when planning your organization's long-term future. Dilution will not place you in an extremely bad situation--even though it does affect your ownership. Dilution is almost often the outcome of an event that improves the worth of your business, such as an investment.

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So, if your share of ownership in your firm falls by 25% - but the firm's valuation (and the value of the stocks you own) rises by 400% - you don't need to be worried about the impact on your bank account. However, regardless of how much your stock is worth, unless you account for dilution and plan for it, you may find yourself in a tricky situation later on. Stock dilution can cause you to lose control of the business by reducing your shareholding.

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Stock dilution, especially due to SAFEs, might be unexpected: Without proper planning, it's easy to see how, you can end up losing some control of your enterprise. This is particularly risky if you're issuing a lot of SAFEs before your first money round, especially if the discounts and valuation ceilings are different. SAFEs might appear to be free cash in the heat of the moment; your organization gets money in the bank account without sacrificing ownership. When you conclude your first fundraising round and those SAFEs turn to stock, everything changes.

That is why it is critical to keep your cap table updated. It informs you how much of your firm you're giving up when issuing SAFEs and how much equity dilution a fundraising round could generate. It greatly decreases your chances of making a costly error and assures that you always know who owns what.

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Term sheets and anti-dilution:  Anti-dilution measures in term sheets are intended to safeguard investors' investments from dilution during subsequent financing rounds. If your firm goes through a "down round," these rounds can be problematic for current shareholders (if the stock price during future funding round is less than it was). Anti-dilution clauses force you to allow additional shares for these investors to compensate for the fact that your stock is cheaper than when they bought it, essentially compensating stockholders for a future down-round.

You may argue that venture capitalists would not want to add these provisions if they believed in your startup. After all, if your firm is going through a hard period, asking you to authorize additional stock would simply exacerbate the problem by increasing the effects of dilution and diluting founders' shares. Your connection with your potential investor will determine whether you accept anti-dilution rules, negotiate new ones, or reject them. Let's have a look at the two basic sorts of anti-dilution in any event.

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Anti-dilution regulations are absolute:  Regardless of whether your next fundraising round is down-round, an absolute anti-dilution provision safeguards an investor's investment. If your investors' shares are diluted; you must authorize more shares and issue them to the investor to make up the difference. Not only does this affect your shares when you raise the next round, but it also puts off potential investors since their shares would be diluted if they invest.

If your potential investor puts an absolute anti-dilution provision on the term sheet, you should question their intentions; as well as their degree of expertise. If they decide to keep it on the term sheet, it's best to let them go. It is unlikely that they are thinking in mutually beneficial terms.

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Anti-dilution regulations are being tightened: Investors are protected from subsequent down rounds by ratcheting measures. A complete ratchet and a weight-average ratchet are the two types. The investor receives a "do-over" in the case of a full ratchet; in the case of a down round, they can repurchase stock at the new, lower price. Full ratchets were formerly more prevalent, but they're now uncommon, and you should be cautious about accepting one on your term sheet.

A ratchet based on weight-average is more realistic. Your investor can still repurchase shares during a downturn in this way. However, instead of paying the new price, they pay the weighted average of the Series A and Series B rounds.

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