For many investors, dilution is like kryptonite.
Without price protections, a solid ownership share in a startup can quickly be eaten away during subsequent rounds of investment. The dilutive impact of subsequent investment activity is especially painful during down rounds, when new shares of stock are sold at a price per share that is lower than the price paid in previous investment rounds.
But how are VCs and early investors impacted during an up round? Is it possible for current investors to realize a net benefit during an up round, even if they experience equity dilution?
Absolutely . . . But before you get too excited, you need to understand a few basic points about up round funding and how equity dilution in an up round plays out for investors.
What is an Up Round?
Additional rounds of investment fall into two categories: Down rounds and up rounds. In a down round, investors see both the value of their stock and their ownership share in the company decrease. A down round is often a sign that the company is failing to achieve desired levels of growth or is encountering other difficulties.
In an up around, new shares are issued at a higher price than they were during the initial investment rounds. Early investors see the value of their stock increase while their equity share decreases because there are more investors.
Up Round Benefits
Up rounds aren't necessarily a bad deal for investors, even if the investor experiences a decline in his equity share of the business. The key is to differentiate between equity value and share value.
Follow the logic: For the sake of simplicity, suppose you invest $1,000 in a startup worth $10,000. If each share is worth $1, your 1,000 shares represent a 10% equity interest in the company. In a subsequent up round of investing, an additional 10,000 shares are issued at a price of $2 per share. From an equity standpoint, your ownership in the company dropped from 10% to 5%.
But that's not as bad as it seems. Why? Because although your equity share decreased, the increase in share price means that the shares you purchased for $1 are now worth $2. You've doubled the value of your investment without risking any additional funds. That's a pretty good deal, especially if your investing goal was to make money rather than to own a long-term, controlling interest in the business.