Is ‘dilution’ bad for shareholders?

You hold shares as a founder or an early investor in a startup, and the next investment round will result in dilution of your shareholding.

Is that necessarily a bad thing?

What is dilution?

The term ‘dilution’ refers to a reduction of the percentage that a particular shareholder has in the shares in a company due to an issue of new shares in the company. The number of shares held by the shareholder stays the same.

What about pre-emption rights?

Usually shareholders are protected by ‘pre-emption rights' contained in the articles of association of the company and the investment agreement.

Pre-emption rights are rights by existing shareholders to buy new issued shares before they can be offered to any third party. The rights are proportional to that shareholder’s existing holding, so that for example, if the shareholder holds 20% of the shares, the shareholder will be entitled to 20% of the new shares being issued.

Am I protected by pre-emption rights?

You should check that pre-emption rights have not been disapplied – that usually requires a special resolution of the company to have been passed by a 75% majority of the shareholders.

Also some shares, for example ‘C ordinary shares’, do not have pre-emption rights.

What happens if I don’t invest in the round?

If you don’t invest in the new shares, your shareholding will be ‘diluted’ since the total number of shares will increase, whilst the numbers of shares held by you will remain the same.

Does this mean I will lose out after a new investment round?

If the company is doing well, your shares should have a larger value than before the investment round despite your percentage holding being decreased.

Are there exceptions?

If you hold a large percentage of shares before the round, you might lose statutory rights that you have under the Companies Act 2006. The relevant thresholds at which you will lose important rights are 25%, 50% and 75%.

Do you need advice about your startup? 

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