How does this dilution thing work exactly?

Basically, the way stock works, is that you buy "shares". What you pay for them in the public markets changes with every offer to sell and purchase made. The price is quite literally what the market will bear (no bull we hope - inside Wall street type of joke). If it's a public company and the shares are traded (bought and sold) on a public market (e.g., the New York Stock Exchange), the value of your stock changes every time shares are sold, but you only realize the results when you sell yours. You make (or lose) the difference between what you paid for it and what you sold it for (just like a used car - but that's a different story for another day).

Private equity is the same way. However, private companies usually authorize a total number of shares, allocate portions of them to different purposes, and issue (usually sell) some portion of them at a time (hopefully to accredited or sophisticated investors - this for another day) in exchange for money, goods services, etc.

Classes of shares and preferences

I discussed this last month, but just in case...

Typically, when formed, a "C" corporation (founded under the IRS regulations for the way you pay taxes but also related to what you can legally do regarding bookkeeping and other legal issues) is created with some number of authorized shares. These days I see many companies use 10M shares as the initial authorized number. You can authorize more if you need them some day, typically with the approval of the shareholders (or the board) by way of a vote (see the preference issues above).

These shares are authorized and allocated to (divided into) different pools. Here's an example I use with CEOs:

ClassClass AClass BClass CClass D
NameCommonNon-dilutivePreferredEmployee
Allocated %50%10%30%10%
Allocated shares5,000,0001,000,0003,000,0001,000,000
Table of allocated shares for a total of 10M shares authorized

As shares are sold by the company (for whatever value, including equity in other entities), they are issued. For example:

ClassClass AClass BClass CClass D
NameCommonNon-dilutivePreferredEmployee
%50%10%30%10%
Allocated5,000,0001,000,0003,000,0001,000,000
Issued1,000,000222,2221,000,0000
Table of issued shares at founding

Then comes a round of financing

ClassClass AClass BClass CClass DTotal
NameCommonNon-dilutivePreferredEmployee
%50%10%30%10%100%
Allocated5,000,0001,000,0003,000,0001,000,00010,000,000
Previously Issued1,000,000222,2221,000,00002,222,222
Pre-money$1,000,000$222,222$1,000,000$0$2,222,222
Newly Issued1,000,000111,111001,111,111
Newly Issued %90%10%0%0%100%
Total Issued2,000,000333,3331,000,00003,333,333
Total %60%10%30%0100%
Post-money$2,000,000$333,333$1,000,0000$3,333,333
Table of issued shares before and after a $1M common stock financing round

Of course you might be able to sell preferred or non-dilutive shares for more than common stock, which means that the different classes of stock may have different prices, even if they are worth proportionate amounts of ownership interest in the company. For example that non-dilutive equity seems to be worth more than the other classes (and it is).

Please remember, we are not lawyers, accountants, or securities experts. We do help you understand things so your lawyers will spend less time teaching you and letting you know about things you were previously unaware of, but they will probably spend more time correcting our errors...

So who got hurt?

Actually, nobody got hurt here. The old dilutive shareholders now own a smaller percentage of the company, but the value of their equity is now established at $2M ($1M common and $1M preferred). No employees were involved, and the new shareholders bought $1M of stock now reasonably valued at $1M.

However, the folks who used to own 90% of the company now only own 60% of the company, while the new investors own 30%, and the non-dilutive folks still own 10%. As a result, the previous common and preferred owners own a smaller percentage relative to the non-dilutive owners. So they were diluted.

It's a year later and you need more money

ClassClass AClass BClass CClass DTotal
NameCommonNon-dilutivePreferredEmployee
Authorized %50%10%30%10%100%
Allocated5,000,0001,000,0003,000,0001,000,00010,000,000
Previously Issued2,000,000333,3331,000,00003,333,333
Pre-money$6,000,000$1,000,000$3,000,000$0$10M
Newly Issued1,666,666~185,18500~1,851,851
Newly Issued %90%10%0%0%100%
New Totals Issued3,666,666~518,5181,000,000~5,185,184
New Total %70.714%10%19.286%0100%
Post-money$10,999,998$1,555,552$3,000,0000$15,555,552
Table of issued shares before and after a subsequent $5M common stock financing round at $30/share

In case you forgot, we are not lawyers, accountants, or securities experts. This is just the best I understand this now. But the new investment of $5M at $3/share plus the non-dilution of Class B stock brought the new valuation up to $15,555,552, and essentially increased the valuation of the non-dilutive shares by $555,552.

Who got hurt this time?

The original dilutive shareholders, who started with 80% of the equity, now own 2M shares at $3/share, or $6M of the total value of $15.555M, or 40% - the non-dilutive shareholders have 10% (worth $1.55M) - and the investors now own about 50% - which is controlling interest. If it weren't for preferences, they could then do almost anything with the company. Now you know why preferences can be important protections against dilution.

Suppose the company sells in 2 years with no further financing for $100M (not too shabby). Then the non-dilutive will get $10M, the original dilutive shareholders will get $40M, and the investors will get $50M. The price per share will be $100M/5,185,184, or $19,285/share

Just to be clear, most of the time, none of this matters, because the company fails and nobody gets anything back, or at best the preferred shareholders get a portion of their investment back.

A call to action

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But consult your SEC licensed securities law firm before you make any actual decisions about legal issues such as these.

In summary

Now that you know more than I do about this subject, check with your accountants and SEC registered investment professionals and send me updates so I can find out what I got wrong here and how to fix it...

We are all learning all the time.

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