Diluting Shares vs Reserving Shares

Question

I often read about a startup company diluting its shares, in order to provide additional shares for an investor during an investment round. This means that the ownership % for the co-founders is reduced during the investment round. I assume that this is necessary because 100% of all shares have already been issued to the co-founders and employees, and so there are no shares left over to give the investor.

But an alternative would be to only issue some of the shares to the co-founders and employees (e.g. 70% of the shares), so that there are still shares remaining to give to future investors (30% of the shares, in this case). This way, the co-founders' ownership % does not decrease during each investment round, and this might be easier to manage (if, for example, the co-founders always want to have more than 50% of equity).

Why do companies tend to do dilution, rather than reserving a portion of shares for future investors?

Answer 1

Shares outstanding are shares that have been issued and purchased by investors and held by them. Authorized shares is the maximum number of shares that the company is allowed to issue (according to its charter).

When calculating your percentage ownership of a company, it is the shares outstanding that matters. For example, if a company has 700 shares outstanding, and you own 350 shares, you own 50% of the company.

I often read about a startup company diluting its shares, in order to provide additional shares for an investor during an investment round.

Suppose the co-founder and employees currently own 700 shares, and the number of shares outstanding is currently 700. In other words, the co-founder and employees own 100% of the outstanding shares (and therefore own 100% of the company).

Then, a new investor comes along, and the company sells 300 new shares to this investor. The number of shares outstanding is now 1000, of which 70% is owned by the co-founder and employees, and 30% is owned by the new investor. The co-founder and employees' shares have been diluted. They used to own 100% of the company, but they now own 70%.

But an alternative would be to only issue some of the shares to the co-founders and employees (e.g. 70% of the shares), so that there are still shares remaining to give to future investors (30% of the shares, in this case).

In other words, you propose to have 1000 authorized shares, with 700 issued to the co-founder and employees, and the remaining unissued shares (300 shares) can later be given to future investors.

Will this prevent dilution when the 300 shares is issued to the future investors? No. It's exactly the same story as above, which I repeat here:

Suppose the co-founder and employees currently own 700 shares, and the number of shares outstanding is currently 700. In other words, the co-founder and employees own 100% of the outstanding shares (and therefore own 100% of the company).

Then, a new investor comes along, and the company sells 300 new shares to this investor. The number of shares outstanding is now 1000, of which 70% is owned by the co-founder and employees, and 30% is owned by the new investor. The co-founder and employees' shares have been diluted. They used to own 100% of the company, but they now own 70%.

Why do companies tend to do dilution, rather than reserving a portion of shares for future investors?

You seem to believe that "reserving a portion of shares" and later issuing them to future investors will not result in dilution. This is not the case, as I have just demonstrated above. If you issue new shares (i.e. increase the number of outstanding shares), you are diluting the existing shares.

Answer 2

It is very rare that a company issues all of its shares. Typically a bank of shares are kept in reserve for the kind of things you are thinking about.

In fact large companies often have buybacks of shares while at the same time issuing shares through ESOP and sometimes 401k matching which seems counter intuitive and inefficient. However, it is playing the games in the press to bolster stock price, a company buying back shares get a lot of attention while issuing shares through employee benefit programs does not. Furthermore, it cost the company very little to provide ESOP and 401K matching through company stock yet is highly valued by the employee.

Regardless, if a full partner comes into a business and that person will be issued a founders amount of shares, all owners will be diluted. It will not matter if the shares come from a those held by the company or new shares are issued.

If XYZ company hold a number of shares, and you own stock in XYZ, then you own a portion of those shares in respect to the percentage of XYZ you own. If XYZ management then chooses to give those shares to a new partner, then you no longer own them and thus diluted.

Other than the administrative cost to issue new shares the situation you describe will result in any existing owner being diluted. This would also hold true if a new class of stock is created.