One of the most misunderstood areas of early-stage investing is dilution. I receive lots of questions from investors about what dilution means for their investments and whether it is a bad thing.
Dilution is a natural part of the investment process and we see it as generally something to be embraced rather than feared. Sometimes predatory dilution can be used to take advantage of smaller shareholders, but the investor protections on Seedrs means that the dilution you see on a Seedrs investment is generally more likely to increase the value of your investment than to decrease it.
Here’s a little story to illustrate why:
William logs into Seedrs and browses the startup listings. A listing called Toybucket catches his eye: it’s an online platform for renting toys and is an SEIS eligible listing. It has been set up by a young entrepreneur called Ruby who describes it as “LoveFilm for toys” and they are looking to raise £50,000 in exchange for 20% of the company. This is a post money valuation of £250,000. William thinks it has huge potential and invests £500. 99 other investors agree with William and decide to invest and the listing goes on to reach 100% of the funding it is looking for. Seedrs completes its due diligence, finalises the paperwork and the funds are transferred to Toybucket Ltd’s company bank account. Seedrs now manages 20% of the shares as nominee for the 100 shareholders, including William. William now owns 0.20% of Toybucket.
Ruby sets off and works tirelessly on Toybucket and makes fantastic progress, receiving positive press and steady customer growth. The time comes when she needs to raise a further £150,000 to hire a key developer to help with her website and increase her marketing spend. She submits a new listing to Seedrs, looking to raise £150,000 in exchange for 15% of the company. This is a post money valuation of £1,000,000. Under the shareholders’ agreement that Seedrs entered into with Toybucket, William has pre-emption rights, which entitles him to purchase further shares in Toybucket to enable him to keep his ownership of Toybucket at 0.20%. However he decides not to exercise his pre-emption rights and instead invests the money in two other companies on Seedrs. Ruby successfully raises the money and Seedrs performs the same tasks as before and transfers the funds to Toybucket Ltd. Because William did not exercise his pre-emption rights, he now owns 0.17% of Toybucket.
Three years later, Ruby has done incredibly well. The company has 22 staff and is turning over £15 million per year. Yahoo, which has been on a bit of a spending spree recently, has agreed to buy the company for £30,000,000. William’s shares, which represent 0.17% of the company, are now worth £51,000. Oh, and by the way, the £50,500 profit that William has made is completely tax free, as it was an SEIS eligible investment.
Is William bothered about being diluted from 0.20% to 0.17%? I don’t think so…
The above is a made up story, but it describes a pattern that happens all the time in private equity. Provided that a company is raising more money at the same or higher valuation than at the time when you invested, the fact that such a round of financing will dilute you is not necessarily a bad thing. The slice of the pie that you own is getting smaller, but the size of the pie is getting bigger.
William could have exercised his pre-emption rights and invested more money to maintain his 0.20% – this “follow-on investing” is a very valid way of investing. But choosing not to follow his money, and accepting the dilution, is equally valid. He didn’t make quite as big a profit in Toybucket as if he had invested more. But then again, the story could very well have ended up with Ruby having to wind up the company because there was no demand for online toy rental; meanwhile, one of the other investments that William made with the money that he saved from not exercising his pre-emption rights might have been in a company that was subsequently bought by Google. By accepting the dilution and using his money to diversify his portfolio, William has increased his chances of having a major success.
What this all comes down to is that dilution and diversification are two sides of the same coin. We all know that diversification is vital when investing in early-stage businesses (see our recent post on the effect of diversification for a visual representation of why). But sometimes diversification means passing on the chance to invest more in the same company – and thereby accepting a bit of dilution – in order to use your funds to invest in new companies. And when that’s the choice, it’s easy to see why dilution isn’t the scary concept it is sometimes made out to be. Instead, it is a natural part of the investment process which should be welcomed and embraced.