Along with specific risk factors, disclosing ‘dilution’ is one of the most important sections of a private placement memorandum. It’s one of the first sections investors review when reviewing a potential investment.
Look at it this way, if you were investing your money, wouldn’t you want to know whether your equity position in the company was going to remain at a certain percentage to secure your investment? Many investors have been burned by unscrupulous entrepreneurs who methodically diluted the investor’s ownership down to near zero. Most notably, it happens on the Penny Stock Exchanges. However, many professionals are predicting this will happen in the new Crowdfunding space, which is why many have expressed concerns about fraud.
Assuming a company only needs 1-2 rounds of capital to get started, it can work out great for investors. However, if the company starts burning through cash it can be devastating for everyone.
Here’s how dilution works:
1. Let’s say you start the company with 30,000,000 shares authorized for use.
2. You issue 10,000,000 of those shares to founders at .001 per share (par value) or $10,000. These shares are classified as ‘common shares.’
Note: This scenario can get even more complex if the entrepreneur issues ‘preferred shares’ and allows them to become convertible into common shares, e.g., 5 common shares for every 1 preferred share. Voting rights can also become an issue here. But for our scenario let’s keep it simple.
3. Your current ‘book value’ is $.001.
($10,000 ÷ 10,000,000 shares = $0.001 per share)
4. You then reach into your Authorized Share pool and offer 4,000,000 common shares to new investors in a Reg D Rule 504 Private Placement at an assumed value of $1.00 per share, based on projections, patents, trademarks, intellectual property, etc. You raise $4,000,000.
5. After this first capital raise you will have issued 14,000,000 shares which now defines the percentages of ownership at 71% (founders) and 29% (new investors).
Note: Ownership percentages are figured by ‘issued’ shares NOT ‘authorized’ shares.
6. After the offering is sold and closed, this leaves you with 16,000,000 shares for further issuance later (from the pool of authorized shares).
7. With the cash infusion of $4,000,000 your new book value is $0.29 per share.
($10,000 + $4,000,000 = $4,010,000 ÷ 14,000,000 shares = $0.29 per share)
8. This leaves the ‘dilution per share’ to first round investors, at $0.71 per share.
($1.00 – 0.29 = $0.71) or (Stock Price – Book Value = Diluted Value)
9. After receiving investment capital from first round investors, and closing the offering, you immediately start raising more capital using a different Reg D Rule, e.g., Rule 504 for the first offering and Rule 506 for the second offering. I.e, you can only use Rule 504 once every 12 months, but you can use Rule 506 immediately following the close of a 504 offering.
10. Let’s say you sell and issue 2,000,000 more shares from the pool of Authorized Shares at $2.00 per share, raising an additional $4,000,000.
11. After the sale and close of this second offering your new capitalization total is $8,010,000.
($10,000 + $4,000,000 + $4,000,000 = $8,010,000)
Note: This is all assuming you don’t have expenses to deduct from the capitalization total. If you have expenses those would be deducted from the total when figuring the book value. This is only for the sake of our scenario.
12. This brings your new book value to $.50 per share.
($8,010,000 ÷ 16,000,000 shares = $0.50 per share)
13. Second round investors experience an immediate dilution of $1.50 per share.
($2.00 – $.050 = $1.50) or (Stock Price – Book Value = Diluted Value)
14. Now the ownership percentages change to 62% (founders), 25% (first round investors) and 12.5% (second round investors). Founders lose 9% and first round investors lose 4% of their equity ownership.
15. The company still has 14,000,000 shares to issue from its Authorized Share pool.
(30,000,000 – 10,000,000 – 4,000,000 – 2,000,000 = 14,000,000)
Every time the company raises more capital, issuing more shares, the percentage of ownership decreases for the previous investors. If the company starts burning through capital, and needs to keep raising money, the first round investors could end up owning less than 5%. Moreover, if the company continues burning through capital without replacing the capital with revenue (and profits) the book value of the stock drops along side the ownership percentage. We call this a ‘death spiral.’
So, you can see why some professionals are concerned about dilution, and also, why it’s important to disclose this information to new investors.
Thanks for reading and best of luck!
Here’s our dilution formula:
Stock Price – Book Value = Diluted Value
Diluted Value ÷ Stock Price = Dilution Rate