What it means, its impact on your portfolio and an example of how it works!
At the start of the year, we learned about how JP Morgan acquired a startup called Frank for $175m, to learn that due diligence wasn’t carried out properly and are now clearing out a messy public legal battle.
Angel investing is an extremely fulfilling form of investing as you get to work with some very talented and exciting people who have ambitions to change the world. However, investing without the right education can be very dangerous and lead to costly mistakes. Understanding how equity, dilution and returns work is a critical skill to gain before making an angel investment.
There are many pitfalls you need to be aware of before writing your first check. Here is an example of a blog post we wrote to help you educate yourself before making your first investment: The 3 biggest mistakes angel investors make when investing in startups.
One key term that angel investors need to be aware of before angel investing is the word dilution.
What is dilution?
In angel investing, dilution refers to the decrease in percentage ownership that an investor has in a company due to the issuance of new shares of stock. Dilution occurs when a company raises additional capital by selling new shares of stock to new investors or by issuing stock options or warrants to employees or other stakeholders. This happens when a startup raises a new round of funding.
When a company raises new capital, the total number of outstanding shares increases, and the ownership percentage of existing shareholders decreases. Dilution can be significant in early-stage companies, where multiple rounds of funding may be required to finance growth and development.
For angel investors, dilution can have both positive and negative effects. On the one hand, dilution can be a sign that the company is growing and attracting new investors, which may increase the value of the investor’s remaining shares as the startup’s valuation increases. On the other hand, dilution can also decrease the value of the investor’s existing shares and reduce their potential return on investment.
As an angel investor, it is important for you to understand what dilution means as dilution can have a significant impact on your portfolio and as a result your returns.
Here is a numerical and simple example of how an angel investor can be diluted:
Let’s say an angel investor invests £100,000 for a 10% ownership stake (pre-money valuation £500,000, post-money valuation £1 million) in a startup company that has 1 million outstanding shares of common stock. This means the investor owns 100,000 shares of the company.
The startup company later decided to raise additional capital by issuing 500,000 new shares of common stock to new investors at a valuation of $2 million. This means the new investors are collectively investing £1 million in exchange for a 50% ownership stake in the company.
After the new investment round, the total number of outstanding shares of common stock is now 1.5 million. The angel investor’s ownership percentage is now diluted to 6.67% (100,000 shares divided by 1.5 million shares). The investor’s percentage ownership has decreased due to the issuance of new shares but due to the increase in the company’s overall valuation, the angel investors investment still increased in value (£1 per share during the pre-seed round vs. £1.33 per share during the seed round.).
In this example, we can see how dilution works and how this angel investor experienced dilution of their ownership percentage from 10% to 6.67% due to the issuance of new shares of stock.
Here are 5 steps you can take to avoid dilution in the future:
Angel investors can avoid dilution or reduce its impact by taking the following steps:
- Negotiate favourable terms: As an angel investor negotiate protective provisions in an investment agreement, such as anti-dilution provisions, which can protect your ownership percentage in case the company issues new shares in the future.
- Stay involved in the company: To maintain your ownership in a company, make sure you have capital allocated for follow-up rounds to increase your ownership stake in the company and avoid dilution. Be aware this often involves investing more than you did in the first round you invested.
- Help the company grow: You can help a company grow and achieve milestones by leveraging your networks, experience, and industry knowledge. A growing company is likely to have a higher valuation, which can mitigate the impact of dilution.
- Invest in convertible debt or preferred stock: You can invest in convertible debt or preferred stock, which can provide you with certain rights and preferences, such as the ability to convert your investment into equity at a later date at a pre-agreed valuation.
- Diversify your portfolio: You can diversify your portfolio by investing in multiple companies. This can help reduce the impact of dilution in any one company and improve the overall risk-return profile of your investment portfolio.
While dilution is an inherent risk in angel investing, taking these steps can help angel investors mitigate the impact of dilution and increase the potential for a successful investment outcome.
Interesting to learn more about how equity dilution could impact you in the future. Look no further, check out this FREE Dilution & Equity calculatorby our friends U2R.