Anyone thinking about bringing in equity capital to their business has to look the bogeyman named “Dilution” in the eyes and decide if they are prepared to accept it. Dilution is a reduction in the percentage ownership of a given shareholder in a company caused by the issuance of new shares. If you own one hundred percent of your company and you want to raise money by selling shares, you can either sell some of your own or issue new shares from treasury. If you sell half of the issued (your) shares you now only own fifty percent of the company. If you issue new shares from treasury it will still dilute your ownership but with a different result. For example, if there are 100 shares in your company and you issue 50 new shares to an equity investor, you still own 100 shares but now that’s represents 66% of the 150 issued shares of the company. The good news is you’re still the majority shareholder. But what if you need more? What if, to be successful, you need to issue 300 new shares? Now you own only 25% of the company.
So is dilution a good thing or a bad thing? For the shareholders, many perceive it to be a raw deal. Their stake in a company gets watered down when new shares are issued to fund a takeover deal or raise money for working capital. For the company, it’s a good deal as the company now has the funding to take it up a notch. Therefore the right answer is - neither. Dilution is just simply a necessary thing that happens when an entrepreneur sells a slice of his/her enterprise to raise money to take the company to the next level. This will hopefully provide greater returns for everyone.
Do not be afraid of dilution. I often hear entrepreneurs ask “How much of my company will I have to give up when I take in new investment?” and it is exactly the wrong question. Instead of worrying about your stake, you must consider what you are gaining. Often the additional funds come with experience, support and connections that will be vital to the on-going growth of your business. But make sure these elements of support are real before you do the deal. You have to find the right balance of ownership, value of investment, value of the company and long-term growth strategy. Ask yourself “When I’m hungry, would I rather have 10% of a watermelon or 100% of a grape?”
The best way to reduce the effect of dilution is to increase company value. Let’s say your company is worth $50,000 and you own 100%. You want to increase the amount of growth capital and issue 300 new shares at a share price of $500 per share and bring in $150,000. You now own 25% of a $200,000 company. If you use that $150,000 to make your company worth $1 million, your value at $2,500 per share is now $250,000. Everyone has seen a five times increase in their share value.
Outside investors will sometimes insist on an “anti-dilution” provision with their investment. If their initial investment gives them 5% of the company they will automatically have their number of shares adjusted on future outside investment so they maintain their 5% ownership.
An important problem for future investors are entrepreneurs who gave up too much of the company too early at too high a valuation and - as a result - the follow on investors are faced with founders that don’t own enough of the company. It’s that ownership that provides the founder the stimulus to drive the company forward. An unenthusiastic founder will produce lack-luster results.
At the end of the day, the most important thing is the success of the company. For an entrepreneur, the decisions they make in the early stages of growing their company can have far reaching consequences that can either assist or inhibit growth. They need to carefully assess growth strategies, company/share structure and strings attached to any investment in order to keep their company positioned for long-term success.
About the Author
Ross Finlayis a co-founder and Director of the First Angel Network Association - Atlantic Canada’s association for private investors. Ross has been an angel investor since 2000; as well, he has assisted a number of companies raise private equity. He is a recognized facilitator, business planner, and strategic change advisor who has an extensive background in public, private and not-for-profit sectors.
He has assisted in the development and review of countless business plans for start-up companies. Ross has extensive business networks throughout Atlantic Canada and is a regular columnist for Atlantic Business Magazine.
Ross has been Executive Director of a professional association in Ontario and President of a national consulting company specializing in providing consulting services in scientific, engineering and technical fields.
Ross has managed his own successful consulting practice. He returned to the corporate world for a time with PricewaterhouseCoopers and a Nova Scotia based software development company.
Ross brings added value to his clients through his unique blend of experience and competence. This includes business planning, full P & L accountability, strategic planning, development of new visions and initiatives, budgeting, financial planning, and human resource management.
In 2002 Ross was a recipient of the Queen Elizabeth II Jubilee Medal for outstanding service through his efforts in numerous charities.