2. Ownership Dilution

A justified concern of the VC in the previous example could be that the current round of financing will not be the last one before the exit. For example, the VC could believe that the current round of financing will help the firm enter the market but that the capital will not suffice to also finance the subsequent growth strategy.

For the VC, the problem with such a scenario is that any future round of financing will dilute his equity stake of 20%.

 

To make this more tangible, suppose that between the VC's investment and the exit, there is another round of financing in which the new provider of capital requires an ownership stake of 20%. What are the implications of this second round of financing for the VC?

  • If the new investor receives 20% of the equity, the VC and the entrepreneur together will own 80% of the firm. Of these 80%, the VC has 20%. Therefore, the VC's claim will be diluted from 20% to 16% [= 0.2 × 0.8].
  • Assuming the exit value does not change (180 million), the total exit value for the VC will be 16% of 180 million, namely 28.8 million.
  • With an initial investment of 6.7 million, this implies an annual rate of return of 33.9%, which is below the hurdle rate of 40%:
     
    Return to VC after dilution = \( (\frac{\text{Exit value}}{\text{Capital investment}})^{0.2} - 1 = (\frac{28.8}{6.7})^{0.2} - 1 \) = 33.9%.

 

Consequently, the dilutive effect of the second round of financing implies that the VC cannot cover his "cost of capital." Because the firm will need additional capital in the future, the original deal structure is not attractive to the VC.

Now what could the VC do to protect against this dilution? The separate module Deal Structuring looks in detail at some of the popular anti-dilution protection mechanisms in venture financing. Here, we just look at a simple solution:

  • For the VC, it is important to receive 20% of the exit value (assuming this exit value does not change with the various rounds of financing)
  • If there is an additional round of financing for 20% of the equity, this implies that the future ownership structure of the firm should be as follows:
    • Entrepreneur: 60%
    • VC: 20%
    • Second round investors: 20%
  • Put differently, the VC will want to make sure that the only the entrepreneur's ownership stake will be diluted.

   

To solve the problem, we can go back to the previous procedure and slightly adjust the equations:

  • Under the new scenario, the newly issued shares will account for 40% of the equity (20% for the VC and 20% for the second round investors). Consequently:

  

Newly issued shares = 0.4 × (Current number of shares + Newly issued shares);

Newly issued shares = Current number of shares × \( 100'000 \times \frac{0.4}{(1-0.4)} = 66'667 \).

  

Consequently, the firm will authorize 66'667 shares so that the total number of shares outstanding after the second round of financing will be 100'000 + 66'667 = 166'667.

Of these newly authorized shares, 33'333 will be issued to the VC [= 166'667 × 0.2]. The remaining 33'333 will then be issued to the new investors during the second round of financing.

Consequently, the issue price for the VC will drop from 268 in the previous example to 201 under the revised financing scenario:

 

Issue priceVC = \( \frac{\text{Capital invested}}{\text{Newly issued shares to VC}} = \frac{6'700'000}{33'333} = 201 \).

  

At the time of exit, the firm will then have an expected value of 180 million with 166'667 shares outstanding. Therefore, the expected share price at the time of exit will be 180'000'000/166'667 = 1'080. For the VC, this expected price development implies that he can expect to earn his hurdle rate of 40%, on average:

  
Expected returnVC = \( (\frac{\text{Expected exit price}}{\text{Issue price}})^{0.2}-1 =(\frac{1'080}{201})^{0.2}-1 \) = 40%.

  

This example has shown how an investor can protect himself against the dilutive effects of future round of financing. The trick was that he already anticipates these future rounds of finance and consequently asks for a larger number of shares to absorb dilution. The result in this simplified example is that the entrepreneur bears the full dilution of all future rounds of financing.