"Sorry, my Prada's at the cleaners!"
Understanding Share Dilution- Definition, Math, and Impact
Introduction
We all remember the iconic Andrew Garfield scene, “Sorry! My Prada's at the cleaners! Along with my hoodie and my ‘fuck you’ flip-flops, you pretentious douchebag”, from The Social Network, directed by David Fincher (hands down, one of my favorite directors). It's a movie based on real-life events surrounding Facebook's creation, focusing on themes of ambition, betrayal, and the consequences of success.
But before diving deeper, you can read my previous newsletter about the key takeaway from my finance class at NYU, here.
Continuing further, Here’s the dialogue exchange in this scene, involving Mark Zuckerberg and Eduardo Saverin (who co-founded Facebook in 2004, serving as its first Chief Financial Officer and business manager), along with their respective lawyers-
Eduardo’s lawyer: "What was Mr. Zuckerberg's ownership share diluted down to?"
Eduardo: "It wasn't."
Eduardo’s lawyer: "What was Mr. Moskovitz's ownership share diluted down to?"
Eduardo: "It wasn't."
Eduardo’s lawyer: "What was Sean Parker's ownership share diluted down to?"
Eduardo: "It wasn't."
Eduardo’s lawyer: "What was Peter Thiel's ownership share diluted down to?"
Eduardo: "It wasn't."
Eduardo’s lawyer: "And what was your ownership share diluted down to?"
Eduardo: ".03%"
The theme for today’s newsletter is to understand share dilution from the first principles, broken down into four parts- the definition, the math, relevance to The Social Network, and the impacts of share dilution.
Share Dilution- Definition
Equity dilution is defined as the decrease in equity ownership for existing shareholders that occurs when a company issues new shares. Typically, a founder starts out owning 100% of a company and, every time capital ($) is raised or shares are issued, that ownership stake is reduced. This is why equity dilution is sometimes called founder dilution. It is also known as stock dilution, share dilution, private company dilution and startup dilution. [1]
Raising capital is an interesting topic, which I’ll cover in detail in my next newsletter.
Share Dilution- The Math
Assume that you start your company by making at an initial investment of $1000.
Initial valuation of your company = your initial investment = $1000 - (i)
Note that the initial valuation of the company is the same as your initial investment, hence you own 100% of your company.
You decide to break this valuation into 100 small pieces (shares).
The value of each share = $1000/100 = $10 - (ii)
You decide to raise a capital of $1000 (100 new shares)to expand your business.
New valuation of your company = initial investment + capital raised = $2000 -(iii)
Total number of shares = initial shares + shares through capital = 200 - (iv)
Note that the total number of shares in the company went from 100 to 200 after raising capital, but the total number shares that you own are still 100.
Thus, your ownership is now = (number of shares that you own)/ (total number of shares) = 100/200 = 50%.
Note that your ownership has gone down from 100% in (i) to 50% in (iii)- this exact phenomenon is called as share dilution.
The math is fine, but what does share dilution mean in the context of Facebook, and what are its impacts on business?
Share Dilution- Relevance to The Social Network
The key idea here is that by issuing new shares (raising capital), through the math mentioned above, only Eduardo’s 30% ownership (and not Mark’s, Thiel’s, or any other investors’ ownership) was diluted down to less than 5%. This meant that, when Facebook went public, he received a smaller percentage of the valuation than he otherwise would have. In short, imagine your ownership dropping from 30% ($300M) to 5% ($50M) in a $1B company. By the way, Facebook is valued at $1.75T today.
Out of curiosity, you might wonder, how did they manage to dilute only one person’s ownership, and not everyone else’s ownership too, when, mathematically, that shouldn’t be possible? (food for thought!) However, In the case of Facebook's share dilution affecting Eduardo Saverin, the process [2] was more complex and strategic than simply issuing new shares to other shareholders-
Facebook created a new corporate structure, moving from a Florida LLC to a Delaware corporation.
In this process, new shares were issued in the new corporate structure.
These new shares were distributed to existing shareholders and new investors, but Saverin was excluded from this distribution.
As a result, while Saverin retained his original number of shares, these shares now represented a much smaller percentage of the total company ownership.
Other shareholders, including Zuckerberg, received additional shares in the new structure to maintain or increase their ownership percentages.
Share Dilution- Impacts
As inferred from the case study above, one of the key impacts of share dilution is diminished financial returns. Other than that, as your ownership stake decreases, so does the ability for an investor to influence the company’s strategic direction and key decisions. This can be a hurdle if the new investors have different goals or priorities. Moreover, when new investors come in, their interests may not perfectly align with those of an early backer. This can lead to conflicts and suboptimal outcomes for the company. [3]
Conclusion
The next few newsletters that I’m going to write here are going to be about finance for startups and entrepreneurship, based on the lessons from my finance class here at NYU. These letters are also like notes to myself, which I can refer to during my career journey down the line.
You can read the previous newsletter, in which I wrote about the biggest takeaway from my finance class at NYU, here.
Thank you reading.
If this newsletter taught you something new about financing in startups,