Even though dilution is a term that pops-up quite often and is widely discussed online, it tends to be misunderstood. In this guestpost, Stefani from Valuation company Equidam explains what dilution means and how investors and economists can have different views on it.
There are two statements in general you can hear out there related to dilution:
Future rounds are going to dilute my participation so you should allow me a larger share now to prevent this from happening!
Cash is neutral; you are diluted in terms of control, but if you’d like to avoid dilution you can either buy more shares now or in future rounds
The first statement was offered by an angel and the other by an entrepreneur who knows finance. Keep them in the back of your mind throughout the exploration of this topic. So before we move on, make sure to take a look at these slides:
Now let’s get back on track…
So what are the effects of dilution?
These are the three main effects I have identified:
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Lower control
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Lower cash rights
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Lower participation value
To understand the reasons for a person to be concerned with dilution, it’s important to know the following effects. To give you a complete picture, let’s take a peak at the investor and economist takes on the three effects identified above.
The investor view – or how dilution supposedly affects deal terms
Often, companies go through multiple rounds of financing. The investor is familiar with the fact that future rounds will dilute his participation. Because he wants his stake to remain above certain thresholds, he will ask the company for compensation for this in terms of a larger percentage of the company now.
1| Lower control
Generally a lower final percentage of the company means lower influence of the investor during e.g. board meetings or general discussions. The investor can’t influence the direction of the company and in this way he is penalized. Of course, this can be easily compensated by board seats, control rights, different share classes and so on.
2| Lower cash rights
Even if companies are waiting more and more to give a penny to capital providers, having a lower percentage of the company gives you a lower percentage of the dividends or payout if the company gets sold. Often this is addressed in other parts of the negotiation, with particular rights in case of acquisition or dividends.
3| Lower participation value
While investors fear for this result, it is likely economists would not agree that dilution generates lower participation value. This will be further explored below.
The economist view – or how any financing is neutral to value
Economists like to study the stock market. Extensive research has been done on price effects of mergers and acquisitions and shares issuance. Most conclude that investments lower the share price but this has nothing to do with dilution. Indeed, one of the main theses of corporate finance is that financing is neutral to company value.
And why is that? Well, the main reason is that, under the assumption that the share price is correct, any infusion or effusion of cash is neutral to company value as the value of the company increases (in the case of infusion) or decreases (effusion) by the same amount.
So why does the value go down in reality? The main argument is signalling. A company that issues shares sends out the signal that it thinks its shares are overvalued, and thus the market reacts by lowering the price. However, these small price corrections should not affect private companies in a meaningful way.
So, let’s take a look at our points of focus that an economist might concern themselves with:
2| Lower cash rights
Any financing activity is neutral and an infusion of cash lowers the rights of each share but without affecting the share price, as the new share benefits from the higher amount of cash in the company (which is directly added to the company value).
3| Lower participation value
Under the assumption that the price is right, any cash infusion increases the value of the company by the same amount. This means that if a person owns 100% of the company and her shares are worth $1 Million, an investor invests an additional $1 million. Both of them will end up with 50% but each 50% will be worth $1 million. If another person enters the fold the story repeats. An economist would then judge this argument as invalid.
It is important to understand these phenomena in order to have a clear and fact-based discussion about dilution with investors, shareholders, or business partners in general.
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Much more can be said about this topic. If you’d like to make any additions to my story, don’t hesitate to shoot us a message at @equidamtweets or [email protected]!
