How does a company start with say 100 shares and value gets “crammed” down with more investment? If one party has five of those shares, won’t they always have the five shares and new investors get shares from some of the other 95? Are there shares that cannot get diluted? Golden shares or?
In: Economics
There’s a lot to this question, but I’ll give an example that I hope helps explain the concept and isn’t too not-ELI5…
Suppose you start a company with a partner. You split the ownership evenly: she gets 100 shares of stock, you get 100. And then you bring on an investor: for $1M, you both agree to sell 20 shares to the investor. After this sale, investor has 40 (worth the $1M they paid for it, so each share is worth $25,000) you and your partner both have 80 (worth 80 times $25k = $2M). So the company is worth a total of $5M with 200 shares outstanding.
But then you and your partner have a major disagreement about the future of the company. She wants to go in one direction, you in another. And the investor agrees with her. You take a vote: their 120 shares outweighs your 80, and she becomes the new CEO and you’re fired. You keep your stock (worth $2M) but you’re not on the board of directors anymore.
The new board then votes to create more stock, literally out of thin air. They create 999,800 new shares and split it between them. You get none.
There are now 1 million shares of stock outstanding, but the *overall value of the company hasn’t changed* and remains the same $5M. So now each share of stock is worth only $5, not $25,000 anymore. Your original 80 shares aren’t worth $2M anymore, your ownership has been “diluted” and now your shares are worth only $400. Sorry that happened to you.
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