Navigating the complexities of share dilution is crucial for startup founders, especially tech startup founders during startup fundraising, and/or when setting up employee share schemes like EMI Schemes (Enterprise Management Incentive). Share dilution occurs when a company issues new shares to raise funds or distribute to employees, which decreases the ownership percentage of existing shareholders. Managing this dilution effectively is key to retaining value and control in your company from pre-seed to series A and beyond.

How Share Dilution Works

Consider a simple example: if you own 10,000 shares out of 100,000 total shares in your company, your ownership is 10%. If the company issues 50,000 more shares to raise capital, the total shares increase to 150,000. Your 10,000 shares now represent about 6.67% of the company rather than 10%. Your ownership percentage reduces as a natural consequence of the increase in total shares.

Implications for Founders

1. Reduced Control: More shares in the company mean less control per share owned by founders, diluting your influence over major decisions unless specific rights in your company documents (such as your shareholder agreement or articles) counteract this effect.

2. Potential Decrease in Share Value: If the company's valuation doesn't increase proportionally to the share count increase, individual share value will drop.

3. Potential Increase in Company Value: On the other hand, the capital raised should help grow the company’s value, potentially offsetting the dilutive impact. 10% of a company worth £10m is more valuable than 50% of a company worth £1m.

Strategies to Manage Dilution in Your Company

You cannot generally ‘stop’ dilution because it is a natural passive consequence of adding more shares to your company - it just happens naturally. However, you can ‘manage’ it so that you aren’t taken by surprise by:

• Modelling your Cap Table: Have a clearly modelled cap table before confirming funding decisions and strategies which shows you potential dilution on each shareholder in different funding scenarios. That way you can plan ahead and factor possible dilutions into your funding decisions.

• Avoid Down-Rounds: A down round where you raise at below your last recorded valuation causes enhanced dilution on existing shareholders. Try to avoid them where you can. If you’re faced with a down round, seek advice on strategies to get around dilution issues.

• Avoid Punitive ‘Anti-Dilution’ Terms: It’s standard to offer VC investors down-round protection, so that they have ‘anti-dilution’ rights in case of a down round. In practice, this means they will receive additional shares in the round. However, other than this, it’s best to avoid offering shares or rights for shares which can’t be diluted.

• Focus on Adding-Value After a Round: When you raise investment, it’s a key time to show increased value through effective use of the capital. Consider choosing investors who provide more than just capital, such as expertise and strategic networks to support this.

EMI Schemes and Share Dilution

EMI schemes are a popular method for startups to attract and retain top talent by offering share options, which are a right to acquire shares in the company in future. While beneficial for employee motivation and loyalty, issuing new shares for EMI schemes contributes to dilution in your cap table. It’s crucial to plan how many shares you can allocate to such schemes without excessively diluting existing shareholders. Most companies we work with at Accelerate Law set aside a pool of or around 10% of their cap table for share options for their staff.

Investor Consent Rights and Governance

Investor consent rights ensure that investors have a say in significant company decisions, such as issuing new shares or making substantial strategic changes. The scope of these rights can significantly affect your operational autonomy, making it essential to negotiate these terms carefully during investment rounds. It is often a negotiating point whether investors have a right to approve future fundraising or not.

Pre-emptive Rights to Mitigate Dilution

Pre-emptive rights allow existing shareholders first dibs on new shares to maintain their ownership percentage before the shares are offered to new investors. These rights can be crucial for founders and early investors who wish to retain their influence in the company.

How does it work in practice? As an example, an investor with 3% equity is entitled to invest 3% of the total of the new round. By doing this, they will not be diluted in the investment round. So in a round of £100k, they will be offered the right to invest £3,000. The investor’s right to invest to maintain their 3% is called their pre-emption right. It is sometimes referred to as a pro-rata right.

Pre-emption rights can be waived ahead of a funding round by shareholders by signing a shareholder voting document called a written resolution. Unless your company’s documents require different thresholds, the waiver will be passed if 75% or more of shareholders approve. Pre-emption rights should either be offered or waived ahead of all funding events.

Cap Table Management for Effective Equity Distribution

Maintaining an accurate cap table is crucial, especially when managing multiple rounds of funding and EMI schemes. Using specific tools or a detailed spreadsheet is invaluable for forecasting the effects of new share issues on ownership percentages.

Effectively managing share dilution involves a deep understanding of equity impacts from fundraising and EMI schemes. By preparing for dilution scenarios, negotiating wisely during funding, and choosing the right investors and compensation strategies for employees, you can safeguard your interests and drive your startup towards long-term success. Consulting with financial and legal advisors like Accelerate Law is recommended to tailor strategies that best fit your company’s needs.

Accelerate Law provides strategic and legal advice to startups end-to-end through angel investment rounds and VC funding rounds, which includes supporting with SEIS and EIS matters, flexible funding for example through Advanced Subscription Agreements, and drafting and negotiating investment terms from term sheets through to completion. Accelerate Law also specialise in EMI Schemes for startups. Contact us here to find out more.