Angel Investing: Dilution in an Up Round (Part 1)

A reader writes –

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.

We’ll divide the answer into 3 parts: Part 1 looks at dilution in an up round; Part 2 examines dilution in a down round; and Part 3 goes over some of the measures that you can take to minimize the impact and likelihood of dilution. We’ll start with the fundamentals, so those who just came across this topic would have a chance to understand what dilution is about.

By definition, dilution — or a reduction in your percentage ownership – occurs when your portfolio company issues new shares. When new shares are issued, “the new investor takes a chunk of the company away from you and all other existing shareholders, just as you took a chunk of the company away from the founders [and other shareholders who invested before you, if any],” Paul Graham of Y Combinator explains.

Let’s paint a scenario based on your numbers:

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

• Venture raises $5m by issuing 5,000,000 new shares
• Total no. of shares outstanding: 800,000 + 5,000,000 = 5,800,000
• Each share is priced at $1
• This is called a flat round since the price per share is the same as the previous round
• Pre-money valuation = $0.8m (800,000 shares x $1 per share, or previous round’s post-money valuation since it’s a flat round)
• Post-money valuation = Pre-money + Investment = $0.8m + $5m = $5.8m
• If you don’t participate in this round, you get diluted; your 25% ownership will shrink to 3.45% ($0.2m / $5.8m)
  • In this case, no. of shares you own remains 200,000, with a total of 5,800,000 shares outstanding
• If you want to keep your 25% ownership you’ll have to inject another $1.25m ($5.8m x 25% – $0.2m) in this round, and your total investment in the company comes to $1.45m
  • In this case, no. of shares you own increases to 1,450,000, with a total of 5,800,000 shares outstanding

When the company goes on to raise more money and issues new shares, you’ll need to pump more money into the company again if you want to maintain your percentage interests.

Eventually, you’ll have no choice but to stop following, either because you have no more money to participate or because you no longer want to commit more funds into the company.

So, you get diluted.

Up Round

Dilution isn’t sexy but it isn’t indisputably distressing either. If your portfolio company is doing great and the valuation of which is increasing, “in theory, each further round of investment leaves you with a smaller share of an even more valuable company,” says Graham. In this case, dilution isn’t something you should worry about.

“In fact [dilution is] often a byproduct of success (because nothing sucks up capital like a high growth rate),” comments Basil Peters, a veteran angel investor and an angel investment fund manager.

He continues:

For me, the real question is whether the dilution is accretive to the share value. In other words, I am happy to suffer a 10% dilution if I believe that dilution will add capital to provide an overall 20% increase in share value.

Going back to our example, let’s say you didn’t participate in the 2nd round and your percentage interests dropped from 25% to 3.45%. Lucky for you, the company is gaining traction and is savored and bought by a bigger company for $30m. Now your 3.45%, or $0.2m investment, has become $1.035m ($30m x 3.45%).

Only when the company is sold for, or exit at a value, less than $5.8m (post-money valuation of 2nd round) will you lose money. That is, of course, the simplest case with no other debts and fees involved.

Another way to look at it is this: Say, you paid $1 per share for 200,000 shares. The company’s doing great; it decides to raise money to fuel growth by issuing new shares. New investors are willing to pay $2 per share. Your percentage ownership gets diluted because of the issuance of new shares, but the value of your shares has increased from $1 to $2 a pop. The total value of your holdings has jumped from $0.2m to $0.4m (or $200,000 to $400,000 if you like zeros).

As you can see, dilution isn’t always a bad event. You can get diluted even if your shares and total investment increase in value. As Stephanie Hanbury-Brown of Golden Seeds puts it, “Ultimately investors care more about whether the value of the stock has changed more than whether or not their percent ownership has changed.”

Next, we’ll look at dilution in a down round.