Why share dilution isn’t always something to avoid
We help a lot of UK founders to share equity with their teams. Whether it’s through an EMI Scheme, or an Agile Partnership, or anything in-between, we help loads of businesses to realise the benefits of employee share schemes.
A topic that comes up time and time again is dilution. We often hear concerns around the effect of sharing equity on existing shareholders’ shares. Because diluted shares are worth less, right? Not quite…
In this article, we’ll dive into the topic of dilution, exploring the common concerns that founders have, taking a look at ways to mitigate dilution, before arriving at the reasons why founders should stop worrying about it.
What does ‘share dilution’ mean?
Share dilution is a misunderstood concept. Conventional wisdom encourages far more trepidation than the topic deserves.
To start with, let’s consider what we mean by share dilution. In essence, shares are diluted when a company issues new shares, reducing the ownership percentage of existing ones, or ‘diluting’ them.
While this sounds scary, it doesn’t necessarily mean that the value of these shares has decreased, which is what investors really care about at the end of the day.
The most common reason for a company to issue new shares is to raise capital, but they also might choose to do so to reward employees through a company share scheme.
In both cases, the result is a greater number of shares in circulation, meaning that the existing shareholders are diluted. But this isn’t always bad news.
For example, by taking additional investment the company in question may be able to achieve growth that was otherwise impossible, or by starting a company share scheme, the company can motivate employees to achieve more.
Both scenarios can be positive for the investor, as the result of both would likely be an increase in the value of all shares, including the original shareholders’.
Therefore, while on the face of it share dilution might seem concerning, the devil is in the details.
Founders’ concerns over share dilution
Two of the most frequent dilution-related objections we hear regarding company share schemes are:
“I don’t want my shares to be diluted”
“My investors don’t want their shares to be diluted”
Both of these are understandable.
Founders work hard to create successful enterprises, and investors deserve to receive a return on their investment for placing their capital at risk. Share dilution doesn’t have to be at a variance with either of these. Here’s why:
Founders shares being diluted
Let’s consider the first objection: Founders not wanting their own shares to be diluted.
In some cases, there is little we can do to reassure people - some individuals just aren’t philosophically aligned with the idea of sharing equity.
But speaking objectively: giving your team some skin in the game is proven to benefit your company’s bottom line. Employees who are given equity are less likely to leave, are more engaged, and are more committed to the success of your company, than those without. All of this makes financial and ethical sense.
What’s more - a company share scheme doesn’t have to represent as large of a dilution of your founders shares as you might think. A typical founder will allocate somewhere between 5% and 15% of their equity to an employee option pool, which if it results in significant growth (and it normally does) then this is a small price to pay. ‘Pennies on the pound’ as they say.
Investors not wanting their shares to be diluted
The second objection is slightly less black-and-white.
Convincing someone to invest their hard-earned cash in your business is no mean feat, and founders are right to be wary of anything that might impact the value of these investments.
When starting a company share scheme, many will even rush to say “can’t the options just be issued over my founders’ shares?” so as to avoid this altogether. The simple answer to this question is: Yes, but you might not want to.
As with most cases where equity is involved, the answer to this question isn’t straightforward, and it depends entirely on the founder and the context.
In the next section we’ll take a look at how you can avoid diluting your investors shares - and why you might not want to.
How to avoid share dilution
There are a number of ways of creating a share scheme without diluting individual shares. Whether you should or not is another question entirely.
Each method of avoiding individual dilution has its own merits and drawbacks. These methods include:
1. Issuing options over a specific individual’s shares
It is possible to set up authorisation so that options are issued over a specific individual’s shares - which in this case might be over a founder’s shares, to avoid diluting their investors. The only way to do this is to create a bespoke agreement with a lawyer, which can then be digitised through a platform such as Vestd for onward management once executed. These agreements can involve a great deal of lawyer’s time, which means it gets expensive very quickly.
2. Issuing options over treasury shares
To avoid diluting investors’ shares, you can buy back founder’s shares into treasury, and then issue options over treasury shares instead. Founders should proceed with caution, as once this is done it can’t be reversed - even if options are deferred. And beware of the very specific rules around when a company can and cant buy-back its own shares
3. Issuing unapproved options
Another way to avoid diluting an investor’s shares is to issue unapproved options to the investor at the time that the options are issued. This could be seen as unfair to others, as the shareholder(s) in question would have a stable percentage of ownership each time that new shares are issued, while everyone else’s reduces.
4. Creating bespoke Articles of Association
The final way of mitigating dilution of an investors’ shares is to draft bespoke Articles of Association that stipulate that a specific share class is never diluted. As with the first option, this involves lawyers, and so will cost a pretty penny.
Why founders shouldn’t necessarily ‘avoid’ diluting shares
The drawbacks of these methods likely outweigh the potential benefits - especially when you correct the misconception of share dilution as a whole.
Perhaps the biggest detriment of these is the lack of fairness. The majority of share schemes dilute all shareholders equally by default - and for good reason.
Equity should, by its very nature, be fair - and founders should have a commitment to sharing ownership fairly, or else they are missing at least part of the point. As such, it is important to choose partners and investors who share the same values.
Another reason why founders shouldn’t be so concerned about dilution is that the positive impact of sharing equity has the potential to eclipse the effects of dilution entirely.
After all, owning a slightly smaller percentage of a much bigger pie has to be better than owning all of something far smaller, surely?
That said, there may be times when using the methods for avoiding dilution mentioned above is essential, and therefore it should be reassuring to know that there are tools at your disposal.
If you would like help navigating the complex world of equity, then feel free to book in a free consultation with one of our equity experts. They know this stuff inside-out.