Embedded Files
MedFinVentures.org
Posts, like the one on the right, give you the impression that equity is a static entity whose fluctuation is rare, if at all. In reality, equity concentration and dilution are real phenomenon that can raise or erode your investment, respectively. If you're not careful, changes in your equity position could result in a loss of control of your venture. Let's dissect equity dilution.
Equity
A common way to raise capital is by offering equity in your new venture. Think of it as selling a stake in your company's future cash flow. When you first start, you own 100% of the equity in your company. You start selling portions of your company (shares) to investors to raise capital. What you do with that capital actually matters, but we'll get to that near the end of this exposition.
Once you purchase some equity, your return on investment (absolute $ amount) will be a product of the equity you own and the value of each equity unit ($ per share). The latter can change as your venture prospers or falters. Many forget that the former can change as well, based on decisions that you take as a founder of the venture.
Equity dilution
Most ventures need to undergo more than one round of capital raising. Each time capital is raised, more pieces of your venture are sold to new investors. What happens to the portion of your company that the existing investors, including yourself, hold? If those investors decide not to purchase more equity of your company, their existing equity is diluted. Dilution is a concern for your investors and you.
In the first round, you release 49% of the shares to your company. Series A investors purchase those shares at a particular valuation ($ per share). In another exposition we will talk about how to value a venture. For now, let's just call the valuation Value(A). And by keeping 51% ownership, you maintain total control over your venture while acquiring capital needed to run your business.
Series B capital raise event
Most new ventures need continuous capital to fund operations and maintain solvency - especially if they're not yet in the revenue-generating phase. Non-revenue generating ventures are common in healthcare, as mos of the work is in research & development and outputs are pending regulatory approval.
In the next round of capital raising, you sell more of your venture's equity. In our example, you decide to increase the total equity to 120 shares (from 100 shares at the start). The additional 20 shares of equity are purchased by a new set of investors (Series B investors) at a new valuation (Value(B)).
Notice how your personal equity in your venture, as well as that of the Series A investors, has decreased. Both lost 8% equity in the venture through the issuance of new shares (dilution).
Thankfully, you still own the majority of shares in your venture, allowing you to maintain control, but by a razor-thin margin of 2%. In addition to dilution of equity, you are now at risk of losing control of your venture if Series A and B investors join forces and combine their equity.
So, the costs of raising additional capital in Series B are:
dilution of the equity of the early investors (Series A),
dilution of your own equity, and
increase risk of losing control of your venture.
Series C financing event
Typically, new ventures go through 3 rounds of financing after the pre-seed and seed rounds. Let's say your venture needs to raise more capital in a Series C round, and you decide to sell 20% more of your venture. Again, the new equity is sold at Value(C).
Perhaps no longer a surprise to you, the additional financing event has resulted in even further dilution of equity for the existing equity holders (see graph below).
Your equity: from 51% to 43% to 35%
Series A investor equity: from 49% to 41% to 34%
Series B investory equity: from 17% to 14%
Each time you undertake a equity-driven financing event, you dilute more and more of your ownership in the venture. After this round of financing, you are now in jeopardy of losing control of your venture if any of the investors consolidate their ownership to > 35%.
Offsetting equity dilution
Dilution of one's equity in a venture is such a concern for investors, that they will make deals so that their equity % is protected. Take a look at this short Shark Tank clip and notice how the investor wants protection from dilution in the next round of financing.
Let's see how that works and its effect on your financing efforts.
Non-diluted equity through the next round (Series A to B)
Let's say the Shark in the video above is the Series A investor and controls all 49% of your venture. In the next round, you release 20% more shares of the company, taking the total outstanding shares to 120. If the Series A investor's equity is diluted, she will go from 49% to 41% through no action of her own (i.e., she didn't sell any of her shares).
If she demands equity protection, you will have to raise her equity back to 49% in Series B. To do that, the 17% of shares that would have been available to new investors will have to decrease to 8%
Protecting her equity puts you in two predicaments.
You only have 8% of your venture to sell to new investors (Series B investors), and
You no longer have controlling interest in your venture because your equity was diluted (43% versus 49%).
Regaining control of your venture
To regain control of your venture, you need equity in excess of the next largest equity holder. You'd have to purchase shares of your company to attain 50% equity (1% more than the Series A investor has).
That leaves only 1% outstanding shares remaining to sell to new investors, and the capital raised from just a 1% equity offering may not be enough for you to continue operations. So, protecting an investor's equity can dampen your ability to finance.
I hope you've learned something about equity dilution and can use these tips in growing your next venture. In case you haven't, watch the last 3 minutes of this video (begin at 6:48) to understand the ultimate consequences of losing control of your venture through equity dilution.
Page updated
Google Sites
Report abuse