Why Angel investors need to understand dilution
Late 2023, one of our friends who is an exited non-tech founder reached out saying that he was interested in exploring angel investing. We sat in our local pret a manger and gave him a recap of our journey and offered to help where we can. We were very honest and didn’t pull any punches.
After a few months, he started sending us deals he had seen and we started doing the same and soon enough, he had committed to making his first investment and it happened to be a hot VC led pre-seed round.
As he started navigating the mechanics of term sheets and pre-money and post-money valuations (we will save that for another ‘How to invest’ post), the topic of dilution came up.
Below is a snippet of the conversation we had (our answers are in black), which we thought we’d share to all (with his permission) as it might be useful to others. The notes have been added afterwards by us to aid understanding.
Conversation:
Question - “So, if a company is valued at £2m and has 100 shares, 100 shares being 100% of the company, that’s £20k a share, and I own 1 of those shares, i.e. 1% and I paid, and that 1% share is worth at this valuation, £20k. The company then raises an additional £500k and issues 25 new shares to the new investor, which increases the total number of shares to 125. So, despite still owning 1 share, my ownership stake has dropped from 1% to 0.8% (1 out of the 125) and the new investor now owns 20% of the company (25 out of 125). “
Answer - “Correct”
Note: Make sure you always know your price of share. This is the most important thing.
Question - “So, my, and anyone else's prior to investment / dilution, ownership stakes have declined and the total post-money valuation of the company is now £2.5m? meaning my 0.8% stake is still only worth £20k and hasn’t gone up in value but the company has gone up in value, from £2m to £2.5m but the actual monetary value of my shareholding has not?”
Answer - “Correct, your investment is worth the same”
Note: in reality your investment in a startup is actually worth £0 until you sell it, so don’t start fantasising about how much money you have made!]
Question - “How can the company be worth more, got more money, but my £20k is still only worth £20k?”
Answer - “Good question. The reason is that they are still issuing the new shares at the same share price you paid. So the company is worth more as it now has more shares of ownership but each share is worth the same. Am I not understanding this?”
Note: the valuation increase of the company doesn’t tell you how much your investment has ‘gone up’ in value. The only thing that matter is the value of each share you own and if that has gone up. I.e. if a company continuosly raises money buy issuing new shares at the same share price, the company valuation keeps rising, your ownership % keeps dropping and you ownership value stays the same
Question - “When and why would any VC backed startup ever not issue more shares if they have the option to, to give them out for new raises, BoD, new hires, founders or whomever and however they want and they can effectively dilute me (small investors) down and maintain their %age by just giving themselves more shares?”
Answer - “Theoretically this could happen but it would be very bad governance, would scare off any future investors and would cause very bad press.”
Note: we have seen this happen in highly dilutive new investment rounds, in order to “keep the founders motivated”, This scenario would msot commonly happen in a startup which has taken a lot of time to find PMF (and burned through cash / founder ownership%) but now has some sort of traction and investors think it is still worth a shot.
Question - “How did you get 34x on an investment?”
Answer - “To start with SEIS gives you a 2x start. i.e. if they sell in 3 years for the same value for share you bought, you got 2x and pay no tax on it.... but you need luck. You need them to grow very quickly and hence have a bump in valuation higher than the £ amount they are raising, but luck, LOTS of it. But to properly answer. You either need a rocketship (i.e. >5x val increase each raise) or a profitable steady eddie that grows without needing to constantly raise (and dilute) and then exits at a nice multiple (without having diluted you too much along the way).”
Note: Image generated using DeepAI with the text “why does my money keep shrinking?”
