What is Dilution?

How dilution works

A shareholder's ownership is their shares divided by all the shares the company has issued. When the company issues new shares, the total goes up and every existing holder's share of it goes down, even though nobody has sold anything.

Dilution is not a loss in itself. When new shares are issued at a fair price, the money raised stays in the company, so each existing share is part of a larger, better-funded business. Dilution becomes costly when shares are issued cheaply, for example in a round priced below the last one (a "down round"), or when a large ESOP pool is carved out of the founders' share alone.

Pre-money and post-money valuation

• Pre-money valuation is what the company is worth just before the new money comes in.
• Post-money valuation is the pre-money valuation plus the new money.

The investor's ownership after the round is the new money divided by the post-money valuation. Read a term sheet carefully: a valuation stated as post-money already includes the investor's money, so the founders keep less than the same figure stated as pre-money.

Fully diluted shareholding

Indian funding rounds usually count ownership on a fully diluted basis. That treats every instrument that can turn into equity shares as if it already had: the ESOP pool (granted or not), compulsorily convertible preference shares (CCPS), compulsorily convertible debentures and warrants. Most venture investors in India invest through CCPS, so a cap table that counts only equity shares understates how far the founders have been diluted.

The rules on issuing new shares in India

A private limited company raising money from investors usually issues shares by private placement and preferential allotment:

• The shareholders pass a special resolution approving the issue.
• For a preferential allotment by an unlisted company, the price is supported by a registered valuer's report, and the shares cannot be issued below that price.
• The money must come into a separate bank account and stay there until the shares are allotted.
• The company files the return of allotment (Form PAS-3) with the Registrar of Companies, within the time the rules allow after allotment.

When the investor is outside India, the foreign exchange rules also apply. Shares of an unlisted company cannot be issued to a non-resident below their fair value, worked out by an internationally accepted pricing method and certified as the rules require, and the company reports the issue to its bank in Form FC-GPR within the time the rules set.

The old "angel tax", which taxed a closely held company when it issued shares above their fair market value, does not apply to shares issued from 1 April 2024.

Protection against dilution

Investors' agreements often include anti-dilution clauses. If the company later raises money at a lower price, the earlier investor's conversion price is adjusted down so they get more shares, which dilutes the founders further. Founders should model the effect of these clauses before signing, along with pre-emptive rights that let existing investors take up their share of later rounds.

In the accounts

Issuing shares is a capital transaction: the money raised is credited to share capital and securities premium, not to the profit and loss account. Dilution shows up in diluted earnings per share, which counts the shares that options and convertible instruments could add.