19 Jul Solution for Dilution Confusion
Imagine this day for a moment: you are the CEO and announce to your investors and employees that the company is issuing additional equity ownership and that their equity ownership percentage is being diluted. Chaos ensues. You have panicked existing investors. Employees are up in arms. All because a new investment, or some other issuance of stock in an acquisition, is going to cause their ownership percentage in the company to be diluted. They feel cheated out of hard-earned company value because they have heard that dilution is a bad thing and automatically assume that this lower percentage ownership is going to make their stake in the company worth less. Who can blame them? Who wouldn’t rather own 5% of a company instead of only 3% of a company?
Do not despair! If the company is issuing equity at a higher valuation, the below explanation should help calm this fear.
“The value of your ownership in the company has increased!”
You could simply proclaim, “Congratulations! The value of your ownership in the company has increased!” However, it often takes a good example to show why a dilution of their ownership interest does not result in a dilution of their economic value. I recommend you use some version of the following example to explain this principle:
“When you (employee) received your equity in the company at a $1MM valuation you received a 5% ownership stake, which was worth $50,000 (5% of $1MM). Now, the company is getting an investment at a $3MM post-money valuation and selling 20% of the company’s equity for $600,000. Because this investment is at a higher valuation, we now know the company has increased in value since you received your equity. Yes, your ownership will be diluted to a 4% ownership interest (20% off of the previous 5% ownership) but you will own 4% of a company worth $3MM meaning your 4% is now worth $120,000 (4% x $3MM = $120,000)! That is a great increase on the original value of your equity from $50,000 to $120,000, a 140% increase!”
A new investment isn’t the cause of the increase in value (in the above example, the company was presumably worth $2.4MM just prior to the investment being made), but the valuation put on the company by the new investor is an objective confirmation for owners and employees of how much the company has increased in value.
Ownership dilution is not economic dilution.
Confusion over dilution also arises when an investor or employee demands either (a) that the equity they are about to receive not be subject to dilution or (b) any future issuance of equity requires approval of the investor or employee. Again, you can point out three reasons why such restrictions are not fair to you or any other equity owner:
- The requested dilution would be unfair to every other owner because the other owners would be diluted more than their pro rata share;
- Even when venture capitalists ask for anti-dilution protection, that protection is only if there is some issuance of equity at a valuation less than the valuation that they purchased the equity (i.e., there is not a blanket anti-dilution protection); and
- If the investor or employee fears he may be diluted by future equity issuances, you (the majority owner) can point out your absolute ownership percentage would be diluted much more than theirs, and you think that the new investment causing the ownership percentage dilution is a good thing. For example, if you own 60% of the company and your equity is going to be diluted by 20%, your ownership is reduced to 48% (20% x 60% = 12% and 60% – 12% = 48%) while their 5% equity ownership will just be diluted by only 1% to 4% (20% x 5% = 1% and 5% – 1% = 4%). Also, see the example in the below table to show that, from a percentage perspective, Founder 1 is diluted almost 7.5% and Founder 2 is only diluted less than 1%.
I like to describe this principle by saying that the equity owners are not being “economically” diluted. So, they do not need special anti-dilution rights and should support the new equity issuance, which will cause only percentage ownership dilution. As long as they are not being “economically” diluted equity owners should be happy for a new equity issuance to confirm the good news that the value of their ownership in the company has increased since they received their original equity.
Below is a cap table I recently used to explain to Founder 2 these valuation concepts and that the value of his ownership actually had dramatically increased.
So next time someone complains to you about dilution, use these examples to explain that ownership percentage dilution does not mean economic dilution and that a dilution event can confirm that their value of their ownership has increased dramatically!