For private market investors, waiting for liquidity can be a period of anticipation. As a portfolio company grows, achieves new milestones, and raises additional capital at higher valuations, it is natural for an investor to track valuation growth and attempt to calculate a corresponding return on their investment. However, this method of assessment can lead to a fundamental misunderstanding of an investor’s actual position. In this blog, learn more about valuation vs stock price, equity dilution, and why a 10x growth in valuation might not represent a 10x growth in potential returns.

Valuation vs. Stock Price as a Startup Grows

When a company’s valuation increases over a period of time, it does not necessarily mean an individual investor’s stake has grown at the same rate or multiple. The reason for this discrepancy is equity dilution. As a company matures, the number of outstanding shares increases, meaning that while the company’s total value may be larger, the value of each individual share may not have grown at the same rate.

Investors will want to assess the change in stock price in order to accurately measure an investment’s performance over time, not the change in company valuation. Let’s take a look at SpaceX as an example.

SpaceX’s Valuation vs. Stock Price

SpaceX presents a good example for examining the impact of dilution over time. Elon Musk’s spacetech company has raised significant capital over multiple rounds, experiencing substantial valuation growth. Let’s consider an investment made in its Series M round.

Series M

At the time of the Series M in May 2020, the company’s valuation was approximately $32.5 billion. Investors in that round purchased shares at a price of $220 per share. Following a subsequent 10-for-1 stock split, the effective entry price for that investment becomes $22 per share. More recently, SpaceX completed an additional 5-for-1 stock split, further adjusting the effective entry price to $4.40 per share.

IPO Returns

Looking at today, SpaceX is pursuing an IPO at a valuation of approximately $1.75 trillion, with an implied share price of approximately $135 per share.

An investor who only compares the valuations might calculate a multiple of approximately 53.8x ($1.75T / $32.5B). However, the actual return for an investor who entered in Series M is based on the stock price appreciation. Comparing the effective entry price of $4.40 per share to the IPO price of $135 yields a multiple of approximately 30.7x.

This difference between a 53.8x valuation multiple and a 30.7x stock price multiple is the impact of dilution. The multiple growth is meaningfully different from what a simple valuation comparison would suggest.

What Causes Dilution?

Dilution occurs when a company issues new shares and it is important for investors to understand the mechanisms that cause it, especially when it can impact an investor’s potential return. The following are some of the drivers that can cause dilution:

Capital Raises

The most frequent source of dilution is when a company issues new shares in order to raise capital. When a company brings in new investors, it creates new shares, increasing the total outstanding shares. Existing shareholders, whose share count remains unchanged, now own a smaller percentage of the company. Each subsequent funding round, even at a higher valuation, adds to the total share pool, diluting the ownership stake of prior investors.

Employee Equity Pools

To attract and retain top talent, some startups rely on stock-based compensation. This includes employee stock options, restricted stock units (RSUs), and other equity grants. The shares reserved for these employee pools can be a significant source of dilution over time. For companies like SpaceX, which require specialized engineering and technical talent, these pools are important for building the workforce necessary to achieve ambitious goals, but they also can reduce the ownership percentage of financial investors.

Mergers and Acquisitions

Acquisitions that result in stock in the new entity can be another driver of dilution. When a company acquires another entity, it often issues new shares to the selling company’s shareholders as consideration. The recent merger between SpaceX and xAI is a relevant example. This transaction, which added an estimated $250 billion in value, was accomplished by issuing new SpaceX shares to the shareholders of xAI. This event increased the total share count, meaning the resulting valuation per share was lower than what a simple addition of the two companies’ pre-merger valuations might have implied.

Convertible Securities

Instruments such as convertible notes, Simple Agreements for Future Equity (SAFEs), and warrants can also contribute to dilution. These financial instruments are designed to convert into equity at a future date, typically during a subsequent priced funding round. When conversion occurs, new shares are issued, increasing the total share count. The dilutive effect of these instruments is not always immediately apparent in a company’s headline valuation, making their impact on an investor’s ownership a factor to monitor.

Evaluating Potential Returns

Despite the impact of dilution, valuation can still be a useful metric for investors to consider. It provides a snapshot of a company’s market position, its ability to raise capital, and its relative scale at a specific point in time. However, for the purpose of evaluating investment performance, valuation alone is not enough.

To roughly assess returns, investors should focus on other elements including: the entry share price, the exit share price, and the dilution that occurred between those two points. The return can be calculated by dividing the exit share price by the entry share price. This calculation accounts for the cumulative effect of all dilutive events, helping to provide a more precise picture of investment performance than a comparison of round valuations. It can also be important for investors to remember that a private equity holding can incur many fees which could also have an impact on the outcome.

Final Thoughts

As companies grow it is important for investors to recognize that the valuations do not directly translate into an individual’s investment return. Instead, they should focus on price per share. Dilution, driven by subsequent capital raises, employee equity pools, and stock-based acquisitions, is a standard and often necessary component of a company’s growth. Understanding the distinction between valuation and stock price is a fundamental aspect of private market investing.

Are you ready invest in startups? Sign up for a MicroVentures account to start investing!

Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:

• Due Diligence Red Flags
• Navigating Startup Exits
• Understanding Customer Acquisition Cost
• Evaluating a Startup’s Use of Funds

*****

The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.