When a business raises money through equity investment, it exchanges a share of ownership for capital to fund its growth. This is called shareholder dilution, and it happens because as new shares are issued, the percentage owned by existing shareholders goes down.
For founders and early investors, this is one of the biggest trade-offs of equity investment. The business gains the capital it needs to grow, but the original shareholders may own less of the company and have less influence than before. Understanding how dilution works, and how to manage it, is essential for anyone planning a funding round.
How Equity Investment Works
Equity investment means selling shares in the company in return for money that can be used to develop the business. Shares are sold, and investors expect a financial return in the future.
Funding usually happens in stages:
- Incorporation: Founders take shares when the company is first set up.
- Sweat Equity: Shares may be issued to people who put in time and skills rather than cash.
- Seed Rounds: Early investment, normally with straightforward agreements, where founders usually keep control.
- Series A and Later Rounds: Larger and more complex investments, often involving professional investors who negotiate stronger rights.
Each of these stages generally involves issuing more shares, which increases dilution.
What Shareholder Dilution Means
Shareholder dilution does not mean that existing investors lose their shares. Instead, it means their shares represent a smaller proportion of the company because the total number of shares has increased.
Take a simple example. If a founder owns 1,000 shares in a company with 10,000 shares in issue, they hold 10 per cent. If another 10,000 shares are issued to new investors, the founder still owns the same 1,000 shares, but their percentage falls to 5 per cent. This reduced ownership affects their level of control, their entitlement to dividends, and their share of the proceeds if the company is sold.
Dilution can take different forms:
- Ownership dilution: the most obvious form, where a shareholder’s percentage of ownership falls because more shares are in circulation.
- Control dilution: even if the reduction in percentage ownership is modest, voting power can shift significantly, especially if new investors negotiate special rights or board representation.
- Value dilution: if new shares are issued at a lower valuation than earlier rounds, the value of existing shares may fall. This is often referred to as a “down round.”
Despite all this, dilution is not always negative. If investment allows the company to grow in value, a smaller percentage of a much bigger business can still be worth more. For example, a founder who sees their ownership fall from 20 per cent to 10 per cent may still be in a stronger financial position if the company’s overall valuation has doubled.
The key point is that dilution changes the balance of ownership and influence within a company. For founders, this can mean sharing decision-making power with investors. For early investors, it may mean accepting a smaller share of the company to allow the business to grow.
Crowdfunding and Dilution
Crowdfunding has become a popular way for businesses to raise equity investment. Platforms such as Crowdcube and Seedrs allow companies to attract investment from hundreds of small investors.
While crowdfunding can generate funds quickly, it creates its own challenges. Companies need to check the platform’s terms carefully, including how fees are charged and how investors are represented. Having hundreds of small shareholders is impractical, so most crowdfunding platforms appoint a nominee company to hold shares on behalf of investors. This helps with administration, but the effect on dilution is the same as any other funding round.
Legal Protections for Shareholders
Under the law of England and Wales, a company’s constitution is set by the Companies Act 2006 and its articles of association. When equity investment is raised, additional protections are usually introduced through agreements such as a Shareholders’ Agreement or a Subscription Agreement.
These agreements commonly:
- Set out how new shares can be issued and transferred.
- Define the rights of both majority and minority shareholders.
- Deal with what happens if a shareholder leaves, dies, or is not performing.
- Include “bad leaver” and vesting provisions.
- Reserve important business decisions for majority or supermajority approval.
These provisions do not prevent dilution, but they ensure it is managed fairly and transparently.
How Founders Can Manage Dilution
Although dilution is inevitable in most equity funding rounds, founders can take steps to limit its impact.
Pre-emption rights are one of the most common tools. They give existing shareholders the first chance to buy new shares before outsiders are offered them. This allows shareholders to maintain their percentage holding if they are willing and able to invest more money.
Some companies also issue different classes of shares. Founders may hold shares with enhanced voting rights, allowing them to retain control of decisions even as their economic ownership falls. Agreements can also include drag-along and tag-along rights, which regulate how shareholders are treated if the company is sold.
Control provisions can require that certain fundamental decisions, such as further share issues or the sale of the company, are approved by the founders or by a high percentage of shareholders. With some forward planning, founders can raise capital without losing more control than necessary.
Planning for the Future
Founders need to think not just about the current funding round but about those that may follow. Each round reduces ownership further, so this should always be taken into account.
It is also important to strike the right balance when deciding how much money to raise. Taking in more capital than is needed results in greater dilution, but raising too little can lead to repeated fundraising and further dilution later. Proper financial planning, supported by legal advice, helps avoid both extremes.
Investors may also push for protections of their own, such as anti-dilution clauses. These are designed to prevent their percentage ownership from falling too sharply in future rounds, particularly if new shares are issued at a lower price. Founders should be aware of these provisions and seek advice on their impact before signing.
Get Advice on Shareholder Dilution from JPP Law
Equity investment is a vital part of growth for many businesses, but it almost always brings shareholder dilution. At JPP Law, we support businesses through every stage of the funding journey. Our team advises on shareholder agreements, negotiates investment terms, and helps clients manage the legal and practical impact of dilution.
Contact JPP Law today to discuss your next funding round with one of our corporate solicitors.
