Share dilution refers to the decrease or reduction in the ownership proportion or percentage of shares held by existing shareholders in a company. Instances, where share dilution occurs, include the issuing of new equity by the startup, conversion by holders of optionable securities, or secondary offerings to raise additional capital.
Share Dilution is generally calculated by dividing the existing shares of a shareholder by the total number of existing shares and the total number of new shares.
For instance, Skye Inc. has 1500 shares; Brenda More owns 750 shares, and Claire Pits owns 750. The percentage ownership of the two founders will be calculated as follows:
Brenda More – 750/1500 x 100 = 50%
Claire Pits – 750/1500 x 100 = 50%
Therefore, at this point, each founder owns 50% of the startup.
Subsequently, Skye Inc. issues 500 more shares bringing the total number to 2000. Three new shareholders purchase the new shares in the following order; Shareholder A purchases 300 shares, Shareholder B purchases 150 shares, and Shareholder C purchases 50 shares. The percentage ownership of each shareholder will be calculated as follows:
Brenda More – 750/2000 x 100 = 37.5%
Claire Pits – 750/2000 x 100 = 37.5%
Shareholder A 300/2000 x 100 = 15%
Shareholder B 150/2000 x 100 = 7.5%
Shareholder C 50/2000 x 100 = 2.5%
The above illustration is an instance of share dilution that occurs with the issuance of new equity. Initially, there were only two shareholders (Brenda More and Claire Pits), and their ownership percentage was 50% each. Upon the issuance of the new shares to new shareholders, their 50% ownership was diluted to 37.5% because, with the addition of new shareholders, each shareholder takes up ownership of a part of the company.
In the instance of conversion by holders of optionable securities, when stock options granted to individuals such as employees are converted into common shares, it increases the total share count and, in turn, leads to dilution. As more shares are added to the pool, the ownership of existing shareholders is diluted.
Common to all instances of share dilution is that the ownership percentage of all existing shareholders will be diluted.