Dilution in the context of investment rounds often causes confusion. For SEIS/EIS investors, anti-dilution protections are prohibited; for other shareholders, anti-dilution provisions are viewed as very aggressive and problematic.
This briefing is intended to clarify the position and explain why dilution is not necessarily a bad thing.
What is dilution?
Dilution is the term used to describe the way that the percentage holding of a shareholder in a company is reduced by subsequent issued of shares generally in the context of an investment round. Whilst the number of shares held by the shareholder stays the same, the percentage of the total share capital his shares represents reduces as more shares are issued.
Why does dilution happen?
Each time investment is taken by the Company, new shares are issued (i.e. the Company sells new shares to the investors.) As a result the total number of shares in issue increases meaning that an existing shareholder who does not invest in the new round (and increase the number of shares he holds) will hold a smaller percentage of the new total number of shares.
Does this mean that the shareholders “lose out” when there is a new investment round?
It shouldn’t if the Company is doing well. The reason for this is that the smaller percentage of the Company held by the shareholder should have a larger value than before the investment round.
What protections can be built in to protect investors?
Most investment agreements will contain a provision allowing existing investors a first right to purchase any new shares to be issued by the Company at the price at which they are intended to be issued. This means that if the Company is raising at a low valuation, the existing investors are incentivised to purchase shares to maintain their percentage and/or increase their percentage holding.
Imagine that Shareholder A has invested £20,000 in the seed round and now holds 1% of the entire issued share capital of the Company. The total number of shares in the Company is 10,000 shares meaning that Shareholder A holds 100 shares (100/10,000=1%).
Imagine that a new investor, Investor Z, invests £15,000,000 at a pre-money valuation of £50,000,000. The pre-money valuation of the Company is the value of the Company immediately prior to Investor Z investing his money. In order to work out what percentage of the Company Investor Z should receive, we use the post-money valuation which is pre-money + amount invested (i.e. £50,000,000 + £15,000,000 = £65,000,000.)
Investor Z receives 23% of the Company (£15,000,000/£65,000,000 x 100/1 = 23%). We issue new shares and so Investor X receives 2,987 shares giving a new total share capital of 12,987 shares (2,987/12,987 x 100/1 = 23%).
Shareholder A still holds 100 shares. However, the total number of shares is now 12,987 rather than the original 10,000 meaning that Shareholder A now has 0.77% of the Company (100/12,987 x 100/1 = 0.77%).
The good news for Shareholder A is that the value of his shareholding has dramatically increased. He now holds 0.77% of a Company with an investment valuation of £65,000,000 meaning that his shareholding is (on paper at least) “worth” £500,500.