Say I have invested in a company that has 4 outstanding shares. 3 shares are owned by the founder and 1 by me. Let’s say the valuation of the company is $100.
If the founder wants to increase her ownership share of the company by acting in bad faith, can she issue 96 more shares and sell them to another investor who is her friend?
The company’s valuation does not increase, and my share is only worth $1 now.
Is this a risk all investors take or are there safeguards to prevent this?
It will depend on how the shares are set up - if your 1 share is a separate "class" than the founder's shares as defined by the articles of incorporation, then yes it could be possible. If you've watched The Social Network you see (vaguely) how it played out for Eduardo Saverin and Facebook.
Is this a risk all investors undertake or are there safeguards to prevent this?
No it's not a risk for all investors, or even most investors. If you own common shares in a public company there's not a way for them to just dilute your shares. Corporate actions would dilute all common stockholders equally. Additionally, if something were done fraudulently to dilute shareholders, the affected shareholders could sue for damages.
These are very broad generalizations just to assure you that you do not need to worry about this if you are considering buying shares of a publicly traded company.
If you are getting shares of a startup that you are considering (or already) working for, then yes it might be worth having someone look over the corporate documents to make sure what you are getting actually has value (not just theoretical value, but value that you can actually realize by selling them if you want to).
It's also important to distinguish between diluting the percentage of ownership (which is usually not bad) and the value of that percentage (which is). If you own 2% of a $100k company, and the company doubles its shares but also it's value (via the income from those shares) to $200k, then your percentage is reduced to 1% but the value ($2k) does not change.
Share dilution is a normal process that most companies engage in at some point. Companies may issue new offerings as a way to fund operations and growth. These new issuances absolutely dilute the existing shares. However, this doesn't mean the value of your shares will necessarily decrease. If the company is growing and/or the market has a positive outlook for the company, the shares may stay the same price, or they may actually rise. These new shares will reduce the percentage of ownership existing shares represent, though. Someone who holds a significant ownership stake may lose voting power through these issuances over time if they do not purchase a corresponding portion (to their initial ownership) of the new issuances.
There are cases, however, of shenanigans. In the US and likely many other countries, shareholders may sue for harm in such cases. I'm not a legal expert so I won't attempt to detail what would be considered a case worth pursuing, but there are definitely law firms who take on such cases. For example, this law firm appears to specialize in such cases in closely held companies:
In a closely held company, shareholder dilution can occur when new shares are issued, resulting in a reduction in the ownership percentage and voting power of existing shareholders. This can happen accidentally or with the intent to try to ‘squeeze’ the minority shareholder out of the company (along with several other motivations). IN either scenario, the shareholder has rights and needs to move quickly to enforce them.
Note that in the above they clarify that this doesn't need to be intentional. 'Fraud' as mentioned in the question is also not required for dilution to be considered harmful to the minority shareholders.
The company’s valuation does not increase, and my share is only worth $1 now.
Not quite ...
Before the share issuance
The valuation of the company is $100. You own 25% of it, so your one share is worth $25.
After the share issuance
The worth of one stock is $25, so the new investor must pay $25 * 96 = $2400 for his 96 shares. The company, having taken in $2400 in cash, is now worth $2500 (the original $100 worth, plus $2400 in cash). Your one share of the company is still worth $25.
But what if the founder issues 96 shares for $10 each?
Then you can buy all 96 shares for $960. The worth of the company is now $1060, and you own 97% of it, or $1028.2. Since your original stake was only worth $25, and you invested only another $960, you've made a profit of $43.2. Effectively, you made money at the founder's expense.
If the friend buys the shares for the previous valuation of $25, then the company will be worth $2500 (the original $100 plus the 96*$25=$2400), and you will own 1/100 of that, or $25, so you will have the same value.
If the founder offers the shares for less than the fair market value, then she is violating her fiduciary duty to act in the best interest of the shareholders, and this can be voided by a court.
You state that afterwards, your share is worth only $1, which would require that the founder collected no money at all from the sale. Such an action would be blatant fraud; there would be no argument to be made that it was made in good faith. In such a case, the founder could face criminal prosecution.
