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The Surprising Math Behind Startup Dilution
This recently blew my mind, so I thought I’d share some simple math with you.
Imagine an investor wants to invest in your startup. He says it’s worth $1 million and he wants to invest $500,000. He’s going to take half your company, right? Wrong. He’s going to take one third. At least, that’s the usual math.
In publicly traded stocks, it works the way I’d expect. If I buy $500,000 worth of stock in a company with a capitalization of $1 million, I’ll own half the company. That’s because my stock came from other stockholders. My money went to pay out existing owners.
In the startup world, that’s very unusual. All the old money has to stay to keep the business alive. There’s no “capitalization” yet, not in the sense of capital sitting there doing its job. So when someone invests in your startup, they don’t buy shares from existing owners. They add to its value.
So in the example above,
Don’t believe me? Think about it in terms of share price. Say you have 1 million shares. A $1 million valuation divided by 1 million shares = $1/share. The new investor buys 500,000 shares in your company at $1/share, equaling his $500,000 investment. You create those shares by issuing new shares, rather than by selling him existing shares. Now there are 1.5 million shares out there, and he owns 500,000. So what does the investor own? One third.