Why do startups dilute their equity?

Question

I am trying to understand why, when a startup raises funds, it dilutes its equity by issuing more shares, rather than just issuing a portion of the existing shares.
For example, let's say a startup begins with 100 shares. The founder owns 100 shares, which is 100% of the company. From what I have read, in a funding round, the company will issues more shares, e.g. 100 more, and give these to the investor. So now the founder owns 100 shares out of 200, which is 50% of the company, and the investor owns the same.
But instead of doing this, why doesn't the company stick to a total of 100 shares, and the founder just gives 50 shares to the investor? That way, both the founder and the investor own 50% of the company.

Justin Cave · Answer

Because the goal is for the company to get the investor's money not for the owner to get the investor's money.
If the founder has 100 shares and sells 50 of them to the investor for $1 million, the founder has a nice chunk of change (and the associated tax bill) but the company has no more funds than it had when it started.  Assuming the goal of the funding round is that the company wants to raise money in order to expand, the goal of the funding round has been thwarted.  The founder could take that windfall, pay taxes on it, and then loan it to the company but that would mean that the company got substantially less than $1 million and now had new debt to service which would generally require ongoing interest payments at a time when it clearly wants to keep as much of the money it generates as possible to fund expansion.
If the founder has 100 shares and the company creates another 100 shares and sells them to the investor for $1 million, the company now has $1 million that it can use to hire new employees, buy new machinery, etc.  The founder's equity has been diluted.  And the founder hasn't realized any gains and doesn't owe capital gains taxes.

Why do startups dilute their equity?

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