INSUBCONTINENT EXCLUSIVE:
Eric Paley
Contributor
Eric Paley is a managing partner at Founder Collective
More posts by this contributor
The plague of rationalization
Learning to embrace conflict as a part of startup
culture
Everyone generally agrees that dilution should be avoided
VCs insist on pro-rata rights to avoid the dreaded &D& word
Executives often complain, after a new financing, that they should be &made whole& to offset the dilution that came with the new round
Founders work as hard as they can to maximize their valuation at each financing event to avoid painful dilution
Dilution = Bad.
And yet, entrepreneurs want to raise money
In many cases, they want to raise lots of money
There is great pride in the amount of money that is raised and a larger raise is typically celebrated as a greater success
This is a bit confusing given that a larger raise should also mean more of that awful dilution that everyone is trying to avoid.
Financing
Events Are Misleading
Most people in the startup ecosystem think of dilution as the percent of the company that is sold in a financing
If your startup completed a $5M Series A on a $20M pre-money valuation, (option pool aside) you would have 20% dilution, and everyone will
own 20% less than they did before the transaction
This is very misleading.
While every equity holder may own 20% less of the company than the day before the financing, the company is worth
more than the day before the financing
Even if you assume that the valuation was an objective measure of the value of the company and was flat from the previous financing,
everyone now also owns their percentage share of the new cash that was added to the cap table, which wasn&t part of the company value prior
Here an example:
Company Value
Your Ownership
Your Dollar Value
Pre-Series A
$20M
10%
$2M
Post-Series
A
$25M
8%
$2M
So if you owned 10% of the company, and the day before the financing that was worth $2M, the day after the financing
you own 8% of the company, which is still $2M
In dollar value, which should be the only value that economically matters, you own the exact same amount of a company that is now worth more
Where is the dilution
Financings Are Usually Accretive, Not Dilutive
I believe the startup ecosystem is confused about the impact of
Rather than being dilutive, any upround financing (with a caveat that I&ll address below) should be a demonstration of value accretion
Let add some context to our previous example.
If the previous round had $10M post-money valuation, and you owned 10%, your ownership was
worth $1M at the time of the seed financing
With this new $5M financing on a $20M pre-money valuation, you may now only own 8% of the company, but your value in the startup has
That amazing!
Company Value
Your Ownership
Your Dollar Value
Post-Seed
$10M
10%
$1M
Post-Series A
$25M
8%
$2M
Why
would anyone focus on the 2% reduction in percentage ownership when the value of their holding appreciated from $1M to $2M It always better
to own less of something worth much more than own more of something worth much less
That a trade I&d make every day of the week, and it isn&t at all dilutive to my ownership
Complaining about dilution on that transaction is totally illogical
We should all be celebrating the accretion of value when we have an up-round financing.
If VCs want to purchase their pro-rata because they
believe in the long-term value of the startup, and buying pro-rata is part of their strategy, by all means, they should do so
However, if they are doing so to avoid dilution, I think they&re missing the point completely, given that they haven&t been diluted
If a founder receives more stock options because their performance is outstanding and they deserve more compensation, that terrific
If they are being &made whole& because they own a smaller percentage, that has doubled in value over the larger percentage they previously
owned, that simply faulty math.
True Dilution = Burn Rate & Accretion of Value
While financings reflect value accretion or dilution, the
transaction isn&t where these values really change
Dilution is actually much more complicated and shouldn&t be viewed as a transactional event.
Dilution is a function of your burn rate
relative to your accretion of value
It is often measured in financing events, but it actually plays out every day in the choices the startup makes and the work that the startup
Simply put, if you are accreting more value than you burn, there is no dilution
If you&re burning more cash than you&re accreting value, then there is dilution.
Put another way, you&re not being diluted because a VC
decrees it; you&re being diluted because you spent money building features that your customers didn&t want, instead of the ones that they
You&re being diluted because you kept scaling up an ineffective sales process because you didn&t want growth to slow.
Each financing event
is more of a check-in point on the value of the company than a true dilutive or accretive event
It the time between the financings, when the company was burning cash to build additional value, that was truly the accretive or dilutive
In other words, the company isn&t worth $20M because someone bought stock in a day
Its valuation increased from $10M to $20M because of the work that was done to increase the value of the company that greatly outpaced the
cost of creating that value
If the cost outpaced the value of the work, that would have been dilutive, as demonstrated by a down round.
The Paradox of Overvalued
Financings
It the burn rate relative to the value creation, not the financing event, that truly determines accretion or dilution
However, I&d acknowledge that this equation is ambiguous at all times and the market determines that value, which is why it is fair to say
that financing events are the measuring moment of the most recent period of work.
What particularly complicated is that financing events are
incredibly inaccurate measures of value creation.
In the recent era of an overcapitalized venture capital industry, we&ve seen some
extraordinary financing events across nearly every startup stage
So what is the implication of overcapitalized and overvalued companies Are those transactions clear evidence of value
accretion
Unfortunately, this is a particularly confusing phenomenon
These financings are celebrated because they appear to be minimally dilutive and the company gets a stock-pile of cash
Unfortunately, I think they distort the economic equation of the startup and usually have the opposite result.
Imagine that same startup
that rationally should have raised $5M on $20M pre-money, is able to raise $20M on $80M pre-money.
Company Value
Your Ownership
Your
Dollar Value
Post Seed
$10M
10%
$1M
Post Series A
$80M
8%
$8M
This type of round seems crazy to anyone who hasn&t
experienced it, but we&ve been there with our companies many times
It appears that the company has just had an exceptional outcome
The person who previously owned 10% still owns 8%, but the value appears to have increased from $1M to $8M
Happy days! For the same 20% dilution, the company raised 4X the capital and stock is now worth 8X the last round value! Unfortunately, it
is the embedded future implications of this event that are so misleading and undermine that value.
Because it is the burn rate and not the
transaction that really drives dilution, typically these large financings end up being very dilutive to the company
As I&ve written about previously, these financings often come with unreasonable pressures to prematurely grow the business and incentives to
chase the marginal dollar at great cost
The end result of these financings is typically that the burn rate will often outpace value accretion at the startup
This is extremely dilutive over time and typically will have the effect of conditioning a company for an indefinitely high burn rate, which
will require much more cash and possibly a down round in the future
Or worse yet, the company fails as the investors lose enthusiasm and the company is depending on continued cash infusions that never
come.
In other words, large financings are typically very dilutive, even if on paper they appear to be evidence of massive value accretion
and misleadingly little dilution
Paradoxically, given the same stage of growth, the $5M financing for 20% of the company is often more likely to be long-term accretive, than
the $20M financing for 20%.
Words of Caution
I would encourage startup founders, employees, and investors to stop viewing up round
financings as dilutive and recognize that they are accretive (except when they incentivize future wasteful spend)
Instead, they should obsess about the burn rate and ensure that the capital being burned is invested in high confidence opportunities that
yield true value that will be reflected in accretive future financings
If every dollar invested is showing demonstrable value accretion, by all means burn as fast as confidence allows! Profitability is
important, but focusing on it too early can undermine value in the same way that burning too aggressively can
The point of venture capital is to make investments in confident areas of high growth
Venture capital is not the right tool for every job, but if a startup can use VC as intended, they should.
We had a saying at my last
startup that &every dollar that we spend is a dollar of dilution.& While that was probably a good mindset, the wording suggests that
investing in a business with strong return isn&t worthwhile
Today I&d revise that saying to &every dollar that we spend, that doesn&t create more than a dollar of value, is dilution.&
May your burn
rates be accretive and your financings increase your ownership value.
