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Tuesday, November 20, 2012

Dilution concerns by founders and investors

What is the dollar value of your ownership in the company?

Investors and co-workers in your startup often express dilution concerns.   A past article addressed this issue in part and a description of the need to communicate and educate your investors formed the basis for a different article.  This piece further addresses the issue of dilution as a result of an excellent question from a reader commenting on a recent article covering the summary of a conference.

“Regarding the comment on continually seeking capital: How is it that this approach, though desirable from the point of view of the entrepreneur, is not looked upon with some alarm by investors who will be diluted unless they are the ones who again capitalize the startup?  What's the thinking on that from the investor standpoint? In for a penny?”

The point made in the question is a very real concern expressed by many investors and team members in startups.  Just recently, a company’s team exchanged numerous emails discussing valuation and downstream dilution.  In a different company, the issue of downstream dilution was of high concern to the Angel Investor pool.  Even 15 years ago, a Board expressed these concerns as the company raised capital $18M.  The question is a one that requires thought and consideration as you seek to raise capital.  It even becomes a personal concern should you ever leave the company and the company continues to raise capital.

A few key areas to consider:

Does the capital raise enhance development and increase valuation of the company?

It is important to develop a long-term budget that shows expenditures required to become a profitable company.  Your investors are entitled to know this requirement and understand how it might affect them.  Raising capital for a company that does not increase or may decrease in valuation dilutes all shareholders and decreases the value of their ownership; this does happen by design.  Many times the company does not achieve their anticipated valuation increase and the dilution effect hurts investors.  No entrepreneur ever develops a startup to lose money for investors. They always believe the valuation will increase with development and sales of a product.  Sometimes the company does not capture the desired sales or attention and the company value never goes up. 

Plans to raise capital must fit the company development plan and launch schedule.  Raising all the money up front is dilutive and possibly in a negative way. For this reason, capital raises should take place with increased valuation increments; e.g., the last shareholders bought at $1 / share, the next round is at $5 /share.  Valuation should increase if the company meets their milestones and sales estimates.  The required cash should support this activity.  Many well informed investors will review the proposed spend and accomplishments.  They understand the need to progress while having adequate cash reserves to overcome difficult times.  They expect dilution to take place but look at the value of their ownership as important. 

Does failure to raise capital harm the company valuation?

One way all investors are harmed often occurs when the company needs capital because they are out of money.  The new investors realize there is not gas to fuel the company and they negotiate very hard for a larger piece of the company or a greatly reduced valuation.  Terms like “cram-down” or “down-round” originated from such events over the last 10 years or so.  The phenomenon became a real issue as the year 2000 bubble burst for technology.  The lack of investor interest for several years afterward forced many companies to expend their cash reserves.  These companies may have developed on schedule, but the reduced economy and fear by investors slowed financings.  The firms making investments cherry picked the best companies and negotiated very favorable terms.  Clearly, this form of dilution harmed those not participating because of the down-rounds.  

Are there preferences or anti-dilution provisions that may harm unprotected investors? 

Consideration of preferences and anti-dilution are important, but become less so if you are out of money.  The choice of closing the doors or completing a down-round is difficult for all involved.  No one wins if the company shuts down, so entrepreneurs try to close on a financing under the best conditions possible.  They may try to reduce the harm of liquidation preferences or anti-dilution provisions by trying to negotiate with the holders of these rights.  If successful, the dilution effects in down-rounds are not as bad; however, these deals do not usually work out favorably.

How do you answer the investor concerns?

The important piece of information for the shareholders is whether the percentage of ownership one holds shows an increased value with the anticipated dilution.  It may take time to realize the improvement, but this is an important point. For example, a 10% ownership of a $5M company is $500K, while a 1% ownership of a $1B company is $10MM.  Not all investors or team members accept this at face value and it takes time to help them see the long-term benefit. It takes time to raise capital and requires making countless presentations and developing relationships.  Entrepreneurs must immediately start the networking after each financing round to ensure they relationships are developed and investors are interested when it is time to complete a new round.  The key take home message is it is better to have a small part of a big number rather than 100% of nothing.