You back a company at the seed round, take 5% for your cheque, and feel rather pleased. Three years and two rounds later you check the cap table and you're down to 2.6%. You didn't sell a single share. Nobody did anything to you. That gap is dilution, and understanding it is the difference between watching your stake shrink with alarm and watching it shrink on purpose.
Here's the mechanism in one sentence: when a company raises money, it creates and sells new shares, so the total number of shares grows - and your fixed holding becomes a smaller fraction of a bigger whole.
How does dilution actually work?
Picture a company with 1,000,000 shares. You own 50,000 of them, so you hold 5%. The company now raises a round by issuing 250,000 brand new shares to a new investor. The total jumps to 1,250,000. You still own your 50,000 - not one share has left your account - but 50,000 out of 1,250,000 is 4%. You've been diluted from 5% to 4% by the simple arithmetic of a larger denominator.
That's all dilution is. Your numerator holds steady; the total beneath it grows. Do that across a seed round, a Series A, a Series B and an option pool top-up, and the 5% you started with can comfortably halve or worse by the time anyone talks about an exit. This isn't a sign something went wrong. It's how an angel investment works from first cheque to exit.
When is dilution good and when is it bad?
This is the part the raw percentage hides, and it's the only part that matters. Two investments can both dilute you from 5% to 4% and mean completely opposite things, because what counts is the price the new shares were sold at.
In an up round - the company raises at a higher valuation than last time - dilution is the price of progress. Suppose that round above valued the company at £10m. Your 4% is worth £400,000. If your original 5% was bought when the company was worth £2m, it was worth £100,000. You own a smaller percentage and far more money. A smaller slice of a much bigger pie is the whole point of the exercise.
In a down round - new shares issued at a lower price than before, usually because the company has stumbled or the market has turned - dilution turns nasty. Now you're losing percentage and the value of every share you already hold is falling at the same time. It's the double hit, and it's where the gentler clauses in a term sheet stop being gentle.
A smaller slice of a much bigger pie is the whole point. The trouble starts when the pie shrinks.
Where do anti-dilution provisions come in?
Down rounds are precisely the scenario a professional lead investor protects against. Their preference shares typically carry an anti-dilution provision: if the company later raises at a lower price, their shares are repriced - effectively converting into more shares - to compensate for the fall. It cushions them.
The catch for you is that the protection doesn't come from nowhere. When a lead's shares are topped up in a down round, the extra shares come out of everyone else's percentage. Founders feel it hardest, but ordinary shareholders - and that often includes earlier angels holding ordinary shares - share the bill. So in the round where dilution is already painful, an anti-dilution clause on someone else's shares can quietly make your share of it worse. Whether the clause is "full ratchet" (harsh) or "weighted average" (milder) decides how much worse. It's one of the lines in a term sheet most worth reading slowly.
Don't forget the option pool
New funding rounds aren't the only thing that dilutes you. Companies also set aside shares to pay staff, and topping up the option pool issues - or reserves - more shares, which dilutes existing holders in the same way a round does. The sting is timing: when a pool is created before new money goes in, on a pre-money basis, the existing shareholders absorb it while the incoming investor's percentage stays clean. It's worth knowing this happens, because on a fully diluted cap table the reserved pool already counts against your percentage even before a single option is granted.
What can an angel do about dilution?
Less than you'd like, and more than you'd think. You can't stop a growing company from issuing shares - nor would you want to, since that's how it funds the growth that makes your stake worth anything. But there are a few levers.
- Pro-rata rights. The right to put more money into the next round to hold your percentage steady. Following on this way protects your stake - but only if you've got the cash and the conviction to keep doing it, round after round. Most angels use it selectively, on the companies they believe in most.
- Read the term sheet for the clauses that bite. Anti-dilution terms, the basis of the option pool, and liquidation preferences all change what your percentage is actually worth. The percentage on its own tells you less than the rights attached to it.
- Price dilution in from the start. Assume your stake will shrink across future rounds and judge the entry valuation with that in mind. An angel who expects to be diluted isn't surprised by it; they've already built it into what they were willing to pay.
None of this is about avoiding dilution. It's about distinguishing the healthy kind - the cost of a company growing into a larger valuation - from the kind that signals trouble, and knowing which clauses decide how much of the bad kind lands on you.
Does dilution affect my SEIS or EIS relief?
Not the relief you've already claimed. Being diluted by a later round doesn't claw back the relief you received on the shares you hold. Under the Seed Enterprise Investment Scheme you can claim 50% income tax relief, and under the Enterprise Investment Scheme 30%, both calculated on what you originally put in - provided you hold the shares for at least three years and meet the conditions. Your percentage falling doesn't undo that.
If you put fresh money into a later round to defend your stake, that new investment is judged for relief in its own right, against the scheme conditions and the company's eligibility at that point. The figures and rules sit on gov.uk, and tax treatment turns on your own circumstances - so check the current position there and with an FCA-regulated adviser rather than relying on a rule of thumb from a newsletter.
Dilution isn't the thing to fear on a cap table. A flat share count and a stagnant company is far worse than a shrinking percentage of one that's racing ahead. The work is simply to read the price, read the clauses, and know which kind of dilution you're looking at.