employee equity compensation in tech startups
When a startup has a successful exit, the exit value is divided among everyone with equity. For employees with stock options, your potential payout is determined by the percentage of the company you own at the time of exit.
If the exit value is the proverbial golden pie, then the size of your slice is determined by your stake in the company. Dilution can affect the size of your slice — so let’s explore what dilution is and why it matters.
What is dilution?
When a company creates new shares to give to employees or investors, the total number of shares grows. Although you still own the same number of shares, your stake — the percentage of the company that you own — decreases. In other words, your stake has been diluted.
For example, if you own 100,000 shares and there are 50 million existing shares altogether, your stake is 0.2%. If your company then creates another 50 million shares for new investors, then the total number of shares grows to 100 million, diluting your stake to 0.1%.
Dilution is a pretty common occurrence with startups but isn’t always a cause for concern — more on that below.
When does dilution happen?
Shareholders’ stakes can be diluted in several scenarios, including a fundraising round.
Startups often sell new shares to raise money to propel the company’s growth and/or pay down debt. When new shares are issued, existing shareholders’ stakes are diluted.
A note about preferred shares: When startups issue equity, employees and founders typically receive common stock while investors (like VCs) generally receive preferred stock, which has more favorable terms. Even if a given funding round involves issuing only preferred shares, common shareholders are still diluted, as their ownership percentage will shrink. There are different types of slices, but just one pie.
Dilution can also happen as part of an IPO. When a company goes public, new shares are often issued to raise capital.
As an existing shareholder, your stake can also be diluted when:
How does dilution affect startup employees?
As long as your company’s valuation outpaces your dilution, the value of your exit payout shouldn't be negatively impacted.
In other words, if the relative size of your slice shrinks (dilution), you can still come out ahead if the overall size of the pie grows sufficiently (increased valuation). Fortunately, this is usually the case for startup employees.
Let’s return to our example: You own 100,000 shares. The total number of shares grew from 50 million to 100 million, diluting your stake from 0.2% to 0.1%.
This may feel bad, but it doesn’t need to be. Your stake is halved but imagine if the new investments let your company quadruple its exit value, so your potential payout is actually doubled.
Here’s how that would work:
When all goes well for a startup, it will have a higher valuation in each subsequent round of financing. However, a “down round” can happen. That’s when a company sells stock at a price per share below the price it sold shares in an earlier financing round, presumably resulting in a lower valuation.
For example, Airbnb’s $1 billion fundraise in April 2020 valued the company at $18 billion, below its previous internal valuation of $26 billion.
It’s also worth noting that dilution can reduce your voting power. If your shares come with voting rights, you’ll be granted a certain number of votes per share. Voting typically gives you the ability to elect directors to the board and express your views about major corporate decisions, such as mergers and acquisitions. As your stake in the company declines, so may your voting power.