To understand how dilution works in practice, consider this example. Let’s say the founder of a company valued at $2 million owns 100 shares, representing a 100% ownership stake. To finance growth, the company raises an additional $500,000 and issues 25 new shares to its new investor, increasing the total pool of shares to 125. Despite still owning 100 shares, the founder’s ownership stake drops to 80% (100 out of 125), while the new investor now owns 20% of the company (25 out of 125). After enough equity dilution takes place, the founder’s stake may be reduced to less than 50%, risking the loss of majority voting power.
However, while the founder’s ownership stake has declined, the total post-money valuation of the company is now $2.5 million—meaning the founder’s 80% stake is still worth $2 million. That’s why founders and early investors may be willing to accept some measure of equity dilution as long as the valuation of the company rises.
A challenge arises if, due to market conditions or underperformance, the valuation of the company declines. In this case—or if a founder is at risk of losing ownership control—some founders and early investors may seek protection through anti-dilution measures.
