《海归黄埔军校》课程《股权融资》第一章《股权融资》：A NOTE ON DILUTION
A NOTE ON DILUTION
What is dilution and why is it such a bugbear to investors and entrepreneurs? Many entrepreneurs and even angel investors do not fully understand what is dilution and what is its impact on investments made. While dilution is rightfully a matter of concern, part of the dread arises from a lack of understanding. This note will not only try to clarify this in simple terms, but will also show that dilution is not necessarily always an event that is to be feared and rejected.
Dilution, in the context of our discussion here, is the effect whereby an investor’s shareholding percentage in a company is reduced as a result of the sale of new shares (or the issue of stock options) of the company.
For example an investor may have 10 shares in a company having a total of 100 outstanding shares. The investor hence owns 10% of the company. If the company issues 100 new shares to a new investor, the existing investor would then have 10 out of 200 shares, or 5% of the company. We would then say that the existing investor’s shareholding has been diluted from 10% to 5%.
The following scenarios will serve to explain the impact of dilution on the return from an investment.
An angel investor invested $10 into a company worth $40, thus the company was then worth $50 and the angel owned 20%. The angel helped to build the company and after one year, the company’s value increased to $100. The angel was rewarded by the fact that his 20% was then worth $20; thus he had doubled the value of his investment.
Assume that three years later the company was sold (called a trade sale) for $200. The angel would have increased his gain further. Table 1 illustrates this scenario.
Table 1: Angel is not diluted
|
|
Year 1 |
Year 2 |
Yr 3 |
Yr 4 |
Year 5 |
|
Angel’s investment amount |
$10 |
|
|
|
|
|
Company’s value |
$50 |
$100 |
|
|
$200 |
|
Angel’s shareholding |
20% |
20% |
|
|
20% |
|
Angel’s investment value |
$10 |
$20 |
|
|
$40 |
However, what if the company required significant funding to bring it from a $100 company to a $200 company? Assume a VC invested this significant amount and the angel did not join in. Let us look at various scenarios. Table 2 shows what would happen if the angel’s shareholding is diluted by 50%, from 20% to 10%.
Table 2: Angel suffers 50% dilution after Year 2
|
|
Year 1 |
Year 2 |
Yr 3 |
Yr 4 |
Year 5 |
|
Angel’s investment amount |
$10 |
|
|
|
|
|
Company’s value |
$50 |
$100 |
|
|
$200 |
|
Angel’s shareholding |
20% |
20% |
|
|
10% |
|
Angel’s investment value |
$10 |
$20 |
|
|
$20 |
On the sale of the company, the angel’s shareholding is worth $20. This may be considered fair, since the growth after Year 2 can be attributed to the VC’s funding and help, while the angel did not play any part any more. Thus the angel’s share value remained at $20. If the dilution was less than 50%, the angel would have profited from the VC’s funding and help, as his shareholding on exit would be worth more than $20. Thus dilution is not necessarily always bad.
What if the dilution had been more than 50%? Table 3 illustrates this.
Table 3: Angel suffers 75% dilution after Year 2
|
|
Year 1 |
Year 2 |
Yr 3 |
Yr 4 |
Year 5 |
|
Angel’s investment amount |
$10 |
|
|
|
|
|
Company’s value |
$50 |
$100 |
|
|
$200 |
|
Angel’s shareholding |
20% |
20% |
|
|
5% |
|
Angel’s investment value |
$10 |
$20 |
|
|
$10 |
A 75% dilution is possible, especially if there had been more than one round of VC financing prior to the trade sale, resulting in a cumulative dilution of 75%. Here we see that the angel’s shareholding is reduced to 5% and the value of his shareholding when the company is sold is $10, which is the amount he invested. Thus despite his help to the company in the first year, he had not been rewarded.
You can now imagine a scenario where he gets diluted to less than 5% shareholding. His value on exit would be less than $10 and he would have made a loss on the investment.
Thus, when an angel invests into a company he will have to consider the potential future dilution and compare this to the potential future growth of the company. If the impact of the dilution is greater than the growth of the company, he may not want to invest. Similarly, the founder of a company has to think along similar lines when he is selling shares in his company to an investor. He has to consider the impact of the dilution versus the increased growth that the investment will generate to his company.
(The Second Note on Dilution in the next page provides a simple mathematical discussion of dilution versus growth.)
While a founder who is active in his company will usually be given stock options that will compensate for the dilution, a passive angel investor will not have this benefit. The angel investor may be given the opportunity to follow-on in subsequent investment rounds, but because of his limited funds and the size of the investment rounds, he would be able to participate only to a limited extent, if at all, and would hence be diluted. Even if the angel is protected by an anti-dilution clause in his investment agreement, this clause may be forced to be waived or removed by subsequent investors, especially a large investor who has strong bargaining power.
The angel would then hope that the growth in value of the company would exceed the dilution he suffered, to realize some gain on his investment. He should also realize that without the subsequent investors to grow the company, the company could eventually run out of funds and fail. Thus angel investors should keep in mind the inevitability of subsequent dilution and should factor this in their calculations of return on their investments. Similarly, VC investors need to factor in the possibility of dilution by subsequent financing rounds, when they calculate investment returns.
© L H Wong
Wingz Capital Pte Ltd
December 2006
A SECOND NOTE ON DILUTION
This note follows from “A Note On Dilution” in the previous page and provides a mathematical treatment of the impact of dilution versus the growth of the investee company, and the resultant effect on the returns of an existing investor.
A dilution to the shareholdings of existing shareholders occurs when the company issues new shares or stock options. When a dilution of D% occurs, we define the Dilution Factor as (1-D)%.
For example, an existing shareholder owns 1 million out of the 10 million shares in the company. He therefore owns 10% of the company. If the company now issues 2.5 million new shares to a new investor, the existing investor’s shareholding is 1 million out of 12.5 million shares, or 8%. He has been diluted from 10% to 8%. An issue of 2.5 million shares resulting in an enlarged shareholding of 12.5 million shares means a dilution of 2.5/12.5 = 20%. In this case D = 20%. The dilution factor is (1-D) = 80%.
We use the dilution factor to calculate the resulting shareholdings after a dilution event. The existing investor’s 10% has been diluted by 20% resulting in a shareholding of (1-20%) x 10% = 8%.
Assume the company was worth $10 million when the existing investor invested. Assume the company is sold later for $100 million. If there was no dilution, the existing investor would have received 10% of 100 million, or $10 million. Because of the dilution, he receives 8%, or $8 million. The company would have to grow to a value of $125 million, for him to receive $10 million for his 8%.
Because of the dilution of D%, his shareholding has been multiplied by a factor of (1-D)%, so the exit value of the company would have to be divided by (1-D)%, for him to receive the same return on his investment.
Dividing by (1-D)% is the same as multiplying by 1/(1-D)%. Therefore it can be seen that if the growth of the company is greater than 1/(1-D)%, the existing investor’s return would be increased. This is in spite of the dilution (and in fact perhaps the new investment has generated greater growth). The reverse would of course also apply.
Thus existing investors, including founders, would have to ask themselves this question when considering a new investor: “Will the growth of the company be greater than 1/(1-D), where D is the dilution?” Obviously this is not the only question that arises when raising a new financing round, but it quantifies the impact of dilution and hence would help to alleviate the fears of existing shareholders, such as angel investors and founders, who may not fully understand the effects.
Side Note: IPO Dilution
Careful readers would have noticed that in “A Note On Dilution” the exit event is a trade sale and not an IPO. This is because a dilution occurs on IPO. There is no dilution in a trade sale as all existing shares are sold.
If 25% new shares are issued on IPO, the dilution factor is 75%. The existing shareholder in the above example will have his shares diluted further by a factor of 75% to 75%x8% = 6%. Thus if instead of a trade sale of $100 million, it is an IPO of $100 million with an issue of 25% new shares, the existing investor will receive $6 million instead of $8 million.
The cumulative effect of the two dilutions of D1 and D2 would be (1-D1) x (1-D2).
The existing investor’s 10% original shareholding has been diluted to (1-20%)x(1-25%)x10% = 6%.
The learning point here is that VCs have to keep in mind, when calculating returns, the effect of dilution by the IPO and intervening rounds of financing.
© L H Wong
Wingz Capital Pte Ltd
December 2006
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