Angel Investing: Dilution in a Down Round (Part 2)

A reader recently asked about dilution and we decided to answer it in 3 parts. Part 1 looks at dilution in an up round; this part examines dilution in a down round; and Part 3 goes over some of the measures you can take to minimize the impact and likelihood of dilution.

Here’s the question:

How do you prevent being washed out as you keep pro-rata and the numbers get increasingly bigger?

Suppose you invest $200k for 25%. The venture then raises $5m, so to keep pro rata you do $1.25m of that round. Then it raises $15m. Eventually it gets hard to follow you money and you get diluted down significantly.

Dilution can be scarier than your in-laws. When the company is low on cash and has to raise money in a “down round,” outside investors get to purchase new shares at a price lower than what you’d initially paid. That is, they can buy more with less.

Let’s say the economy takes a nose dive after your investment. (No, we’re not saying you jinxed the company. Sh*t happens.) The company still has great potential but it’s hungry for cash. Existing investors can’t provide the funding it needs so it issues new shares at a price of $0.5 per share in order to attract outside investors.

Using our example in Part 1:

1st Round

• You invested $0.2m in exchange for 25% of the company
• This means the company is implicitly valued at $0.8m ($0.2m / 0.25 = $0.8m), post money
• Price per share = $1
• No. of shares you own: 200,000
• Total no. of shares outstanding: 800,000

2nd Round

• Each share is priced at $0.5
• This is called a down round since the valuation, or price per share, is lower than the previous round
• Venture raises $5m by issuing 10,000,000 new shares
• Total no. of shares outstanding: 800,000 + 10,000,000 = 10,800,000
• The no. of shares you own remains 200,000
• Pre-money valuation = $0.4m (800,000 shares from the 1st round x $0.5 per share)
• Post-money valuation = Pre-money + Investment = $0.4m + $5m = $5.4m
• Value of your investment: 200,000 shares x $0.5 per share = $0.1m
• Your percentage ownership: $0.1m / $5.4m = 1.85%

Do you see what just happened? In a down round, both the size and the value of your holdings are in the race to become The Biggest Loser, shedding pounds off left and right. Your percentage ownership has shrunk from 25% in the 1st round to 1.85% in the 2nd round. Not only that, the total value of your holdings has also dropped from $0.2m to $0.1m. Yikes.

Is there anything you can do to prevent dilution? Martin Zwilling of Arizona Angels Venture Group says no:

Nobody can prevent dilution, if the company gets into trouble and needs more money than planned. The alternative is to watch the company die. Would you rather have a larger percent of nothing, or a smaller percent of something?

Though you can’t prevent dilution if the company needs more money than planned, you can take measures to prevent it, or at least minimize its impact, before it occurs. We’ll look at exactly that in Part 3.