Often, companies will undergo multiple funding rounds to bring in capital. If you invested in their Series A round, you may wonder what will happen to your investment as the company brings in a Series B or Series C round. Dilution occurs when a company issues new shares that result in a decrease in existing stockholders’ ownership percentage. It can also result from the exercising of stock options by company employees or options holders. When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.
What is Dilution?
The concept of dilution is best explained with a visual representation of a pizza. A standard pizza is cut into 8 slices. Imagine there are 4 people who want to split the pizza. Each person receives 2 equal size slices to evenly divide the pizza. Now imagine 2 more people show up and want to split the pizza, the pizza could be re-cut to total 12 slices, and each person still receives 2 equal size slices. However, because the pizza is divided into 12 slices instead of 8, the 2 equal size pieces everyone receives are smaller than when the pizza was divided into 8 slices.
Imagine the 8-slice pizza is a company’s first round of funding. Each investor gets equal size slices of pizza, representing each share. If you purchase 1 slice (1 share) of the pizza, you own 12.5% of the pizza. The company you invested in decides to authorize additional shares at a later date, now dividing the pizza into 12 slices. Your 1 slice of the pizza is now worth approximately 8.3% of the pizza, representing the effect dilution can have.
Because companies often conduct multiple rounds of funding and it is able to impact investment value, it is important for investors to understand the possible effects of dilution. Additionally, some stock issuances include non-dilutive clauses, a perk to keep an eye out for.
Types of Funding Rounds
Companies may choose to conduct multiple funding rounds to address their capital needs; paying for capacity, employees, accelerated growth, etc. Investors that invest in earlier rounds can be more affected by dilution than investors who come in at later rounds. It is important for investors to understand the various funding rounds companies may go through.
- Pre-Seed – typically the first round of funding a company goes through. Pre-seed funding is intended to help the founders get operations up and running. This funding likely comes from the founder(s), family, friends, and close business associates
- Seed – the first official equity funding stage. This funding typically comes from other sources like venture capitalists, incubators, or angel investors
- Series A – commonly occurs when the company has an established track record (established user base, consistent revenue, etc.)
- Series B – typically timed when the company is ready to complete the development phase, intended to further market reach
- Series C – the company may be ready to expand into new markets or develop new products. More types of investors may come into play during this round, such as hedge funds, investment banks, and private equity firms
While these are the major funding rounds companies might go through, all companies are not required to complete multiple funding rounds or any at all. Based on the company’s needs, some companies may never see a benefit to additional funding, as they can successfully grow the business from their revenue. Likewise, companies looking to expand on a global scale may see the benefit of subsequent financing rounds. Many companies utilize additional funding rounds as a launching point to boost their valuation in anticipation of an Initial Public Offering (IPO). There is not one hard set path for companies to take when launching subsequent funding rounds.
In terms of dilution, the round at which investors decide to inject capital into the business in exchange for equity can have an impact on value and return they receive down the line. Series A investors may be affected by more dilution than Series B, Series B investors may be more affected than Series C investors, and so on.
How Dilution Affects Investments
So how can dilution affect an investment in a Series A or B round? Let’s look at the numbers in a realistic scenario.
A pizza company (PC) is raising $200,000 in seed funding. The company has authorized 1,000,000 shares and decides to sell 20% of the company, or 200,000 shares, in exchange for equity at $1 a share. This leaves 800,000 shares, 80% of the company outstanding. You, an investor, decide to invest $10,000 into PC for 10,000 shares. Since the company authorized 1,000,000 shares, you would own 1% of the company (dividing 10,000 purchased shares by 1,000,000 authorized shares and multiplying by 100 to convert to a percentage).
The same company, PC, decides to raise a Series A round at a later date. The company decides to authorize an additional 200,000 shares this round, bringing the total number of authorized shares to 1,200,000. After the seed funding round, you owned 1% of PC with your 10,000 shares. After the Series A round, your 10,000 shares are only equal to about 0.83% of the company’s 1,200,000 total shares.
This dilution may accompany each additional funding round that adds new shares, which decreases the total percentage of the company you own, unless there is a non-dilutive clause in effect. This can be intimidating at first glance, as it can appear as though the investment is losing value. However, the investment may still be worth the same or a greater amount of money if the company’s valuation remains stable or increases.
In the best possible scenario, your investment value can increase as ownership percentage decreases, if the company’s valuation increases drastically. However, these investments are inherently risky, and factors like price per share in the public market, company valuation, how much revenue the company is generating, public perception, and other factors can impact return on investment.
Putting it All Together
Dilution can seem intimidating, but it is a relatively simple concept that may have an impact on your investment, however, not necessarily in a negative way. Boiled down, dilution is when your ownership percentage in the company decreases as the company authorizes and issues new shares for new rounds of funding. If company valuation increases, your investment may become more valuable in the face of dilution, especially if there is a non-dilutive clause in effect. This is why investing in earlier-stage company may have the potential to provide greater returns than in later-stage companies. Investors need to understand dilution and use it to make informed investment decisions. To view MicroVentures’ live investment opportunities, log in to your account.
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.