Dilution in startup fundraising

Understandingthe effects of

DILUTIONFor your startup

OWNER A:100% SHARES

(1000)OWNER A:? % SHARES

(1000)

OWNER B9% shares

? number shares

Why should you know about dilution

HOW BIG WILL YOUR PIECE OF THE PIE BE?

WHY IS DILUTION IMPORTANT?

IT AFFECTS COMPANY OWNERSHIP how much of the company you own and you will keep in the future

IT HAS TO BE CONSIDERED WHEN MAKING AN INVESTMENT PROPOSITION

otherwise, after several rounds, you will end up with a non-satisfying percentage of the shares

IT MAY REDUCE THE VALUE OF THE EXISTING SHARESOnly if new shares are issued at a lower price. Mostly valid for public companies that benefit only marginally

from the capital infusion

DEFINITIONDilution is the reduction of ownership percentages in a company as an effect of the issuance of new shares.

FORMULA

/ Total number of shares after issuanceNumber of shares newly issuedDilution =

EXAMPLEFor an investment round, a company with a total amount of 1000 shares issues 100 additional shares. The dilution caused equals to:

Dilution = 100 / 1100 = 9%

1 - DILUTION

Also called DILUTION COEFFICIENT

DILUTED STAKE = INITIALSTAKE * ( )

100%

9 %

100% – 9%

OWNER A = 100% * ( 100% – 9% ) = 91%

HOW BIG WILL YOUR PIECE OF THE PIE BE?

WHAT IF THERE ARE MULTIPLE INITIAL OWNERS?

OWNER A50%

500 shares

OWNER B50%

500 sharesOWNER A

? % 500 shares

OWNER B? %

500 shares

OWNER C20 %

EACH INITIAL OWNER WILL OWN50% * ( 1 – 0,2 ) = 50% * 80% = 40%

1 - DILUTION

Also called DILUTION COEFFICIENT

DILUTED STAKE = INITIALSTAKE * ( )

WHEN ARE YOU SUBJECT TO DILUTION?

FUNDRAISINGThis is the most typical case, and also the one reflected in the past examples

STOCK OPTIONS OR WARRANTSThey are securities that do not trigger the issuance of shares at the time the contract is signed but they imply that third parties will enter the capital structure in the future

CONVERTIBLE DEBTIn this case, debt holders will convert to shareholders at a trigger event, usually a funding round or an exit.

Dilution

IN FUNDRAISING

DILUTION IN FUNDRAISING

STARTUPS USUALLY GO THROUGH MULTIPLE FUNDING ROUNDS

If you give away more than 20% in the first round

You risk too much dilution

for the founding team

This could be a deal breaker for future investors:they can be afraid of founders not having enough incentives to

commit fully to the company

Future rounds are going to dilute my participation so you should allow me a larger share now to prevent this from happening!“

NEGOTIATING WITH INVESTORS

INVESTORS MIGHT USE A DILUTION ARGUMENT LIKE:

The percentage of shares an investor holds in a company brings him:- Control rights- Cash flow rights

As he/she gets diluted, control rights are affected the most, cash flow rights diminish in percentage but, if the company is performing well, increase in payoff.

DISCUSSING CONTROL RIGHTS

LOWER CONTROL RIGHTS CAN BE DEALT WITH IN SEVERAL WAYS

GET A LARGER INITIAL SHAREBought with more capital at the beginning. Generally not the best option as the risk at this stage is still really high.

TAG-ALONG IN FUTURE ISSUANCESBuy in, at higher valuations, in future share issuances and maintain their percentage. This depends on the investors’ willingness to put up more capital

OBTAIN INDIRECT CONTROL MEASURESThis can be given to an investor by giving him/her a position in the executive board, specific contractual control rights, shares of a different class etc.

Dilution

IN TERMSHEETS

ANTI DILUTION RIGHTS

An example of contractual investors’ protection from future “down-rounds” *

Anti dilution rights are one of the reasons why it’s important to have a fair valuation in the first place.“

* An investment round of which the pre-money valuation is lower than the post-money of the previous round

IN THE CASE THAT THE VALUATION WILL DECREASE, THE FOUNDERS ARE GOING TO BARE THE CONSEQUENCES IN THE FORM OF HIGHER DILUTION.

Most common type of anti dilution rights: FULL RATCHET

FULL RATCHET

DEFINITIONIn a fundraising contract or termsheet, full ratchet clauses give investors total protection against down-rounds. If new shares are issued at a lower price per share, investors with full ratchet protection will receive additional shares and maintain their percentage in the company unchanged.

CONTRACTS ON A “FULLY DILUTED BASIS”

STOCK OPTIONSWARRANTS

CONVERTIBLE DEBT

DILUTION WILL HAPPEN AT A FUTURE EVENT

It is important that all the parties involved in a contract (e.g. stock options, funding, etc.) know what exactly the dilution is be prior to committing to invest.

It’s common practice to make contracts on a “fully diluted basis”

CONTRACTS ON A FULLY DILUTED BASIS

When making contract, the company assumes that the amounts of shares from contracts in place have already been issued, even if that is not the case.

IT AVOIDS A FALSE REPRESENTATION OF THE CAPITAL STRUCTURE AND PROTECTS THE

CONTRACTING PARTY.

=

CONTRACTS ON A “FULLY DILUTED BASIS”

WITHOUT FULLY DILUTED BASISHe doesn’t know about future share conversion, so he thinks he owns

30% of 1000 = 300 shares

WITH FULLY DILUTED BASISHe knows about future share conversionand that he will actually own

300/1600 = 18,75%

1000100500

10001600

Shared issued:Share options:Shares from convertible notes:

Total currently issued shares:Total future shares (FULLY DILUTED):

New investment proposition of an investor for 30% of the company

EXAMPLE

CONTRACTS ON A “FULLY DILUTED BASIS”

Computing Dilution

FOR FUTURE EVENTS

STOCK OPTIONS AND WARRANTS

Computing the future dilution in these cases is relatively simple, because you know already the exact amount of shares that are going to be issued.

You should then follow the formulas in the previous slides.

CONVERTIBLE DEBT

For convertible debt, the situation is a bit more difficult because: There is no certainty in the number of shares that will be issued

In this case,

CONSIDER THE BASE CASE SCENARIOthat is

ASSUME THAT THE DEBT HOLDERS WILL CONVERT AT THE CAP

CONCLUSION

Dilution is inevitable, if you need to raise capital. But don’t worry:

THE GOAL SHOULD BE TO INCREASE THE VALUE OF YOUR COMPANY SO THAT YOU OWN

A SMALLER PERCENTAGE OF A MUCH BIGGER PIE, AND YOUR PERSONAL VALUE GOES UP.

You should now understand how important it is to

KEEP TRACK OF YOUR VALUATIONTry Equidam for Free at www.equidam.com