[1] New equity increases the total shares outstanding which has a dilutive effect on the ownership percentage of existing shareholders.
This increase in the number of shares outstanding can result from a primary market offering (including an initial public offering), employees exercising stock options, or by issuance or conversion of convertible bonds, preferred shares or warrants into stock.
Many venture capital contracts contain an anti-dilution provision in favor of the original investors, to protect their equity investments.
One way to raise new equity without diluting voting control is to give warrants to all the existing shareholders equally.
When employee options threaten to dilute the ownership of a control group, the company can use cash to buy back the shares issued.
Value dilution describes the reduction in the current price of a stock due to the increase in the number of shares.
When this shortfall is triggered by the exercise of employee stock options, it is a measure of wage expense.
As the common shares increase in value, the preferreds will dilute them less (in terms of percent-ownership), and vice versa.
Some financing vehicles are structured to augment this process by redefining the conversion factor as the stock price declines, thus leading to a "death spiral".
These events happen because private companies frequently issue large amounts of new stock every time they raise money from investors.
The issuance of stock to new investors creates significant dilution for founders and existing shareholders.