Understanding dilution is critically important for any entrepreneur who plans on raising venture capital money to help grow their startup. Learn these basics of dilution before you start raising money.
In addition to providing much-needed capital for growing small businesses, venture capital also educates business owners on what it takes to succeed in the real world.
From Day One, the venture capitalist exposes the business owner to a new world of concepts and terms, including one that sends shockwaves of anxiety through investors and owners alike: Dilution.
Dilution refers to a decrease in the ownership position of a company. The reason it is such a concern in venture capital investments is that it can significantly impact the investor's and owner's equity position in the business, the heart of the venture capital relationship.
There are different types of dilution and not all forms of it affect equity positions. But since some forms of dilution do affect equity, venture capitalists are forced to rely on anti-dilution protection to defend their investment.
Percentage dilution is a form of dilution which changes the percentage of stock an investor owns, but has no tangible impact on the dollar value of the investment.
For example, let's say John owns 100 shares of XYZ corporation, which represents 100% of the stock issued by the company. When XYZ sells 100 shares to Bill at the same price, John's percentage ownership is "diluted" to 50%. However, the value of his stock remains the same and his economic position in XYZ is unchanged.
Unlike percentage dilution, economic dilution can have a net benefit or loss for investors. Let's say John bought his stock for $1 a share. If XYZ then sells 100 shares to Bill for $1.50 a share, John experiences an economic gain even though he has also experienced percentage dilution (because he now owns 50% of the company's issued stock rather than 100%).
However, if XYZ sells Bill his 100 shares for $.75 a share, John has experienced both percentage and economic dilution since he paid more for his 100 shares than Bill did for his 100 shares. The bottom line is that economic dilution can be either an asset or a liability, depending on the price at which additional investors are allowed to purchase stock.
Dilution is a particularly sensitive topic for venture capitalists for the simple fact that the sale of additional stock can negatively impact a venture capitalist's equity position in a company.
In response, venture capitalists often rely on measures designed to protect them from dilution. Although these measures can take a variety of forms, the most common method is for the venture capitalist to purchase convertible stock or other convertible investment vehicles in the company.
If the company issues as little as one share of stock below the initial investment price, then the venture capitalist has the ability to convert his stock to the new price level, effectively increasing the economic value of his investment.
Due to the broad range of anti-dilution protection vehicles venture capitalists employ and the economic consequences involved, it's worth the effort to go over any anti-dilution protection clauses with an experienced friend or colleague.
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