Welcome to part two of the Equity Fundamentals series. Today’s article focuses on dilution and discounted participation terms – important concepts for founders and investors to understand.
Let’s get into it.
Quick Key Terms
Shares Outstanding: This is the total number of company shares held by all shareholders but excluding non-exercised stock options and convertibles.
Fully Diluted Shares Outstanding: This is the comprehensive total number of shares that includes non-exercised stock options and convertibles, and is the most accurate representation of company ownership.
When a company raises money, it issues shares, which represent equity in the company. So an investor puts cash into a company in exchange for a percentage ownership in the company, represented by a number of shares.
If that company then raises more money in another funding round, it would need to issue new shares for that cash injection it is receiving. This then increases the number of shares outstanding, the denominator in the % of ownership equation, thereby diluting the existing investors.
Ownership Equation = # of shares owned / fully diluted shares outstanding.
To illustrate how dilution works, let’s continue to use our company from the first article, Zarona. PS. if you’re new to equity, I highly recommend you read that article first.
Zarona currently has 15,000,000 fully diluted shares outstanding. It now intends to raise another round of funding and is targeting a $15m raise at a $90m valuation.
Quick Key Terms
Pre-Money Valuation: this is the value of the company before it receives the investment amount (or raise).
Post-Money Valuation: this is the value of the company after the new money is invested. It is essentially = pre-money valuation + investment amount.
In venture, when the term “valuation” is used without specificity, it almost always means the pre-money valuation.
Back to Zarona:
The company has two existing investors, Bamo Capital and Noxa Ventures, which own 3,000,000 and 2,500,000 shares, respectively.
As Zarona is raising at a $90m valuation, this would mean that its existing 15,000,000 fully diluted shares outstanding are valued at $90m/15,000,000 = $6 per share.
Raising $15m will then create $15m/$6 = 2,500,000 new shares.
This then brings the total fully diluted shares outstanding to 15,000,000+2,500,000 = 17,500,000.
And the post-money valuation to $90m+$15m = $105m.
Impact on Bamo Capital
Before the raise, Bamo Capital owned: 3,000,000/15,000,000 = 20% of Zarona.
Bamo Capital did not participate in this new round of funding – it did not contribute to the $15m raised, so it did not receive any additional new shares. Therefore, its new ownership would be:
3,000,000/17,500,000 = 17.14% of Zarona.
Bamo went from owning 20% of Zarona to owning 17.14%. This means that it was diluted. More explicitly: Bamo Capital’s ownership in Zarona was diluted by 1 – 17.14%/20% = 14.3%.
Dilution Formula #1:
Dilution = 1 – New Ownership % Old Ownership %You may notice that if you divide the raise amount by the post money valuation, you get the same result as the formula above. That’s because that’s another way to calculate dilution.
Dilution Formula #2:
Dilution = Raise Post MoneyA third way to calculate the dilution is by using the shares outstanding.
Dilution Formula #3
Dilution = 1 – Old Fully Diluted Shares Outstanding New Fully Diluted Shares OutstandingImpact on Noxa Ventures
Before the raise, Noxa Ventures owned: 2,500,000/15,000,000 = 16.7% of Zarona.
Noxa Ventures participated in this new round of funding – it contributed $5m to the $15m raised. So it received new shares for that $5m. The number of shares it received was $5m/$6 per share = 833,333 shares.
And its ownership is then (2,500,000+833,333)/17,500,000 = 19%.
But wait.
In most instances, VCs negotiate some sort of discount on participating in subsequent rounds of funding. Noxa Ventures did just that.
Quick Key Terms
Discounted Participation Rights: this is a clause that allows an existing investor to participate in the next round at a discount.
Noxa Ventures negotiated a 20% discount on the next priced round, which means that instead of buying the shares at $6 per share, it would buy them at (1 – 20%) * $6 = $4.8 per share.
If Noxa Ventures decides to put in $5m in this round, it would receive $5m/$4.8 per share = 1,041,667 shares.
With the discount, Noxa Ventures receives 208,334 more shares than it would have without it.
The number of new shares created will also change. If the remaining $10m of the raise is priced at the $6 per share, then $10m/$6 per share = 1,666,667 shares created.
So the total fully diluted shares outstanding would be 15,000,000 + 1,041,667 + 1,666,667 = 17,708,334 shares.
So with the discount, Noxa Ventures would now own (2,500,000+1,041,667)/17,708,334 = 20%.
However…
As if this needed an additional twist, there are two: pro-rata allocation and valuation caps. These two concepts have an impact on how much Noxa Venture can contribute to this round and at what valuation.
I’ll cover those two in the next installment of Equity Fundamentals, so stay tuned.
In the meantime, a knowledge check for you:
Knowledge Check
If Noxa Ventures did not contribute to this round of fundraising, what would its new ownership % in Zarona?
- 20%
- 16.7%
- 14.3%
- 11.8%
Scroll down to the bottom for the answer and see you in the next installment!
Warmly,
Aniekeme
Correct answer: c.
