I have a problem with the word dilution when not used correctly. This is from an interesting article I recently read. I don't agree with everything but it has good points.
In the beginning a start-up company entrepreneur owns a 100% of the company. Sounds impressive, but a 100% of a high risk venture, with no revenues just expenses and a great deal of hope is really 100% of nothing. When cash is needed an entrepreneur has to raise money and it’s the issuance of shares that triggers ownership dilution. This is good dilution because when investors see value they expect a favorable return which means the company must have some accretive promised value. So all things being equal, if an investor acquires 40% of the company for $500,000 and this $500,000 can create even more enterprise value, then the entrepreneurs 60% is worth more than the 100% initial ownership. Good dilution means a share unit has increased in price and when multiplied by the number of shares held by the entrepreneur it means an overall appreciated value of his holdings.
Let’s do the math through a very simple scenario – you own 100% of the company representing 1,000,000 shares at a price $.001 which equals a $1,000 value. You sell 74% of your company at a share value of $.20 by issuing 2,800,000 shares and receive $560,000 in cash for from an investor. Your company now has 3,800,000 shares outstanding, you own 26%, you have $560,000 to help your company reach the next important business milestones and your share holdings are now worth $200,000. Cool!
This is the proverbial – small piece of a large pie which is 200 times greater than a large piece of a small pie. Every time you accept investment you have the power to increase share value and wealth – but it’s up to you!
In the early days new entrepreneurs get hung up on this point and wrongly mix control objectives with share value appreciation objectives. If the company is hitting its milestone along it long term development path then share value will increase, with each raise, and so will the entrepreneur’s share holdings and that of the other shareholders. Percentage Dilution in stock ownership has no direct relationship to the value of the stock ownership position. Therefore, an entrepreneur’s good greed intention or objective should be to build a company’s worth for every share holder.
So greed is good. It is good when share value is created for all shareholders. And if and when there is a liquidity event everyone wins.
For every good side of the story there is also a bad side. Dilution is bad when business value is not created. Enter a new investor. She offers a share price below the previous share prices. In other words, bad dilution occurs when the share value of the current round is less than the previous rounds “cramming down” the share price and ownership percentages of all other previous shareholders.
For example, if the last share round was valued at $.50 per share and the current round is set at $.25 per share this represents a $.25 loss of value. All previous shareholders will experience a devaluation of share ownership and unit share value. This is serious as it represents a setback for these shareholders. These shareholders will “take it on the chin” and experience more than their pro rata portion of dilution. This is bad dilution. It is for these reasons some investors will use anti-dilution protection such as full ratchet adjustment and weighted average ratchet adjustment dilution protection clauses into agreements. (More on this in later blogs).
So the message is clear. Entrepreneurs must create enterprise value by achieving the important milestones promised. This is, of course, easier said than done and there are often unforeseen setbacks. The a singular focus for entrepreneurs, when using other people’s money (OPM), should be on creating intrinsic share price value. Good greed thus creates enduring value.
