Equity dilution, also known as stock dilution, is the decrease in existing shareholders’ ownership of a company as a result of the company issuing new equity. New equity increases the total shares outstanding which has a dilutive effect on the ownership percentage of existing shareholders.
In an equity type of offering- say for example, common stock, the company has already set aside the number of shares they wish to release to investors- so if they offered 10 million shares at $0.01, they have agreed to raise a total of $100,000 and whether you buy 1,000 shares or 10,000 shares, you are getting them at $0.01 regardless. If they decide to later issue (release) more shares to the public then there will be more shares outstanding.
Now, suppose these two scenarios:
- Scenario A: you have 10,000 shares at $0.01. ($100 total invested)
- Scenario B: you have 100,000 shares at the same price, $0.01. ($1,000 total invested)
Also, suppose the company is sold/acquired and when it is sold the new price of each share is now $2.00.
In which scenario are you better off- the one where you did the minimum or the one where you invested more?
Scenario A: $20,000 (10,000 shares x $2.00)
Scenario B: $200,000 (100,000 shares x $2.00)
Of course, you could lose it all in which case you could either lose a)$100 or b)$1,000. This is the exactly what people mean when they say "no risk, no reward" -so higher risk can be potentially higher return but with the probabilities of higher loss too.
What about future funding rounds? How does that affect my shares?
Successful startups host many rounds of financings, all the way to an IPO. For each financing, the startup issues additional stock to the new investors. As long as the value of the company increases with each funding round, this is healthy and normal. For example, the first investor in Facebook, Peter Thiel, originally purchased ~10% of the company for $500,000. By 2011, that stake was diluted down to under 3%, but estimated to be worth ~$2 billion.
Sometimes, when things are not going well, the startup is given the option of going bankrupt or raising more money in a "down round," which means the value of the company decreased since the last financing. This is very bad for the founders and past investors alike; the dilution happens much more rapidly. But it's preferable to the startup going bankrupt and the investors losing everything.