Equity dilution - what is it and why does it matter?
Raising equity capital is highly profiled in the media and sometimes sensationalized. However, its direct and indirect costs are rarely well explained.
In this video, I'll cover:
1) The basics of equity dilution and its terminology.
2) The direct and indirect costs of raising equity capital.
(9 min video)
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Equity dilution. What is it and why does it matter? This video is for you if you're considering raising capital for your business or just want to learn more about equity dilution and its costs. Raising equity capital from angel investors and venture capitalists is highly profiled in the media. Sometimes it can be sensationalized to say the least. However, the costs of it are usually not very well explained at all, especially in the media. In this video, I'll walk through an example of two early stage companies and how equity dilution impacted them quite differently. By the end of this video, you'll understand equity dilution, the basic terminology, and its direct and indirect costs.
Why am I qualified to teach this topic? Founded Pitch Career in 2014 to help entrepreneurs learn the fundamentals of how to communicate with investors and raise capital. Since then, we've taught over 3,000 entrepreneurs and students through courses and classes. I've taught this particular topic many times in incubators, accelerators, colleges, universities, and workforce development programs. One of my goals with these YouTube videos is to demystify the process of raising capital as much as possible. The end of the video, I'll include a couple summary slides you can screenshot and refer back to them later.
Next, let's get into the main topic of this video, which is equity dilution. When you raise equity capital, you'll be giving up a piece of your business to the investors, a piece of the pie. Delution is the percentage of the company that founders or the original owners are giving up when they take on an equity investment. After the investment, investors will own a percentage of the business. The founders therefore will own less of the business than they did originally. Dilution is this direct cost of raising equity capital.
Now, we're going to look at an example of two founders. The first founder CEO raised money relatively early in the company's life cycle. The second founder CEO bootstrapped to achieve as many milestones as possible before raising equity capital.
What's bootstrapping? It means growing the business from cash flow and not raising outside capital. It comes from the concept of being self-sufficient and the term pulling yourself up by your bootstraps.
What does achieving milestones mean? It means anything that increases the valuation of your business. It obviously depends on where your business is at the time, but it could include things like creating an MVP, creating the beta version of your product, creating the release version of your product. Can also be adding people to your advisory board to help you with strategy, adding team members who can help you with the execution of that strategy, getting purchase orders, getting contracts, booking revenue. All these things are milestones that increase the value of your business.
Now, let's get back to our example on the first founder. First founder raised equity capital before the company had achieved many milestones. Because of this, the pre- money valuation of that business is relatively low at half a million dollars. In this example, pre- money valuation of the company is ultimately determined by the investors. It's what they think the company is worth based on milestones achieved to date. It's their perceived risk of getting to those more milestones.
The investment itself was half a million dollars. Investment of this size would usually be from an angel group or similar. The next term is post money valuation which means valuation after the investment. This is a calculation. In this case, let's walk through it. Start with half a money. Half a million pre- money valuation. Add half a million of investment equals a post money valuation of 1 million. Now that we have those calculations, we can determine the ownership after investment.
For the investors, you're going to start with their investment amount of half a million and divide that by the post money valuation of a million. This equals the percentage that the investors own after the investment post money. In this example, the investors own 50% of the business on a post money basis. For the founders, we're assuming they they're the original owners. So after the investment, they own the remaining 50% of the company.
Now, let's take a look at the second founder CEO who bootstrapped the business, meaning grew it from cash flow, tried to be as efficient as possible, and tried to achieve as many milestones as possible before raising equity capital. In the column on the right shows the second founder CEO because the company achieved more milestones, the company got a higher pre- money valuation from investors. In this case, it was 2.5 million. The investment amount was the same, of half a million.
The post money valuation is calculated again. You start with the pre- money valuation of 2 and a half. Add the investment amount of half a million. That equals the post money valuation of 3 million. Now when we calculate the ownership of the investors, it's a much different story. Start with the investment amount of half a million. Divide that by the post money valuation of 3 million equals 17%. Which is how much the investors own after the investment. The founders therefore owning the remaining percentage of the company own 83% of the company which is much higher than in the first example.
Now this was an intentionally simple example but we can also think about what happens if this company needs to raise another equity round of capital without going through all the math again. You can see the situation compounds on itself before the next round of equity capital. The first founder is starting with a pre- money valuation of 50%. And his ownership will get or her ownership will get diluted down from there. In contrast, the second founder is starting with a much stronger position with an ownership percentage of 83% before the next round of investment.
Now that we've covered basic terminology and the costs of equity dilution, we need to also talk about indirect costs and other considerations. Opportunity cost of time is an indirect cost and a big one. Equity fundraising takes a lot of time preparing your materials, finding investors, setting up meetings, working with your corporate lawyer to set up a virtual data room, negotiate a term sheet, finalize the legal documents. This is time you could be using to achieve more milestones, grow your business, and ultimately increase its valuation.
The opportunity cost of time is significant for you as the founder, CEO, entrepreneur, but also for other people on your team. Another consideration is that when you raise equity capital, it comes with future responsibility of the equity investors.
They're investing to make a financial return, not to make a charitable donation. They're looking to you as the founder CEO to be a good steward of their capital and create a financial return on their investment. Also, you're now responsible for keeping them informed on the progress of the business monthly, quarterly, and definitely annually.
We covered the key points and next I'll summarize them in a few slides that you can screenshot. Before I do that, I have a quick favor to ask. If you got value out of this video, there's two things you can do to help us create more videos. One, subscribe to our channel. Two, send this video to someone in your network who might be interested and might benefit. The way YouTube works, it just puts a lot of weight on these two actions that you can take. The more subscribers we have, the more free YouTube videos we can create. It's really that simple.
Next, let's review the key points of this video. First key point, dilution is a direct cost to raising equity capital. It's the piece of the pie that the investors own on a post money basis. Second key point, I walk you I walked you through two dilution examples, two different founders. This example highlighted basic terminology, how dilution is calculated and why you should try to achieve as many milestones as you can before raising equity capital. The third point, there are direct costs and there are indirect costs and there's other considerations of raising equity capital. Opportunity cost of time is probably the most significant indirect cost. The second consideration, after you raise equity capital, you have a responsibility to those investors to keep them informed and create a return on their investment.
Main takeaways of this video, understand all the costs of dilution before considering an equity investment. Discuss the pros and cons with your corporate lawyer, your mentors, and your team. If you determine raising equity capital is the right strategy for your business, try to achieve as many milestones as possible before raising equity capital. This will minimize your dilution.
I hope you got a lot of value out of watching this video and you now have a better handle on the topic of equity delution. I volunteer my time at Pitch Creator for two main reasons. One, your testimonials. Two, your comments and your feedback. I read those comments on these videos. They're the fuel that keeps me and Pitch Creator going. Please keep your comments and testimonials coming. Thank you for your support and thanks for watching this entire video.
