English
One of the most difficult decisions a business owner can take in their career is to decide to raise capital through equity, which will result in diluting the owner’s share in the business and the owner’s control in the management of the business.
Diluting of a founder’s equity in a business is considered a necessary evil when looking to grow said business.
The owner gets a smaller piece of the pie, but it can still be rewarding if the pie gets bigger. We’ll explore here when should owners look to issue new shares, why dilution happens and some of the things they should consider when they are exploring this as a form of financing.
Dilution takes place when business owners look to raise capital to grow their businesses by issuing new shares at a particular valuation and then selling them off to new investors.
The issuing of new shares reduces the percentage of ownership held by the shareholders before the issue as there are more shares floating around. As the level of ownership more or less determines the level of control an owner has in a business, diluting shares can lead to dilution of control.
First and foremost, considering issuing new shares (and consequently, diluting current shareholders) usually takes place if a business has hit its growth ceiling with its current capitalization and needs more funding to grow,
or if a business with growth potential is struggling and is need of a financial bailout and management assistance from new investors that can add value.
It’s a decision that must also be considered along with other financing options (more on that below) and taken if it is the best option. Other reasons to issue shares include as a form of incentive to employees and other stakeholders, if the business does not have enough cash on hand to compensate them directly.
The decision to issue shares and dilute has to align with the owner’s objectives. These could range from risk management – whereby the owner wants to diffuse the risk of the business going under – to increasing the capitalization of the business for growth, or potentially including new investors who can add value to the business.
If the owner is looking for growth, they must have a clear idea what that means (financial or operational growth), what the milestones and KPIs are that would indicate growth, the strategy for achieving these milestones and how much funding they would need to accomplishing them.
The owner must also consider how much direct control they themselves would like to have weighed against how necessary they are to the management of the business.
Depending on what stage of growth the business is in, its financial performance – as measured by the balance sheet and income and cashflow statements – and its operational performance will be crucial in determining:
(a) whether the business is growing or has growth potential
(b) if outside funding is even needed
(c) how much funding is needed
(d) what type of funding is required
(e) the valuation of the business.
This is a crucial step as raising funding through equity may not be the only available option. Other forms of non-dilutive funding can include raising debt, which could offer enough liquidity for growth (and no changes in the governance structure) but can come at a hefty price that could hinder growth in the long run depending on interest rates.
Non-dilutive Islamic financing is also an option. But while these don’t have interest, they do come at a cost. Grants and subsidized, zero-interest loans may also be an appealing financing option but these may be hard to come by.
Read more about: Dilutive vs. Non-dilutive Funding
It can be tempting for those issuing shares to get a massive influx of capital to help the business grow beyond the milestones and objectives of the owner. But without adhering to a solid plan, a founder may end up diluting themselves beyond the needs of the company without efficiently utilizing the resources that have com in.
A cap table is basically a spreadsheet that logs the current shareholder structure of the business and the ownership levels of each shareholder. It is important to use the cap table model out how issuing new shares would dilute the current owners.
Among the most important considerations when looking at balancing dilution and growth, is choosing the right partners who will buy into the capital increase. Some investors can more than make up for the dilution of an owner if they bring enough value to the table.
This could come in the form of experience, mentorship, connections, synergies with other portfolio companies and providing functions and services the business may lack.
Not all shares are created equal, with some types of shares conferring to certain investors greater rights than the rest (preferred shares versus ordinary shares).
These rights include more voting powers in the management of the business, which can help shield the owners from diluting their control to a certain degree. However, shares that confer less rights may not be as appealing to outside investors.
As with the right shares, the right deal can help mitigate some of the dilution. Venture debt, for example, can provide a business with liquidity to grow, which they can pay back in the form of equity at a valuation cap.
If an owner’s growth strategy is long-term, it may be beneficial to space out issuing new shares through multiple rounds (as is common with startups). This can mitigate the impact of dilution by spreading it over a longer period.
It can also help maximize the benefits from a capital increase by allowing the business to grow to a certain milestone before starting the next round of funding, which can increase the valuation of the business in each round.
The linchpin in balancing growth and dilution is the valuation of the business. Owners will try to maximize the value of their business as a high valuation can maximize the capital increase without having to issue too many shares.
Conversely, an investor who sees growth potential in the business would like to maximize their ownership in the business for least amount of capital possible, with an eye towards an exit at a higher valuation.
However, it is crucial not to fall into the mistake of overvaluing the business, as missing growth targets could lead to a drop in the valuation of the company, hurting the owner and the investor in subsequent fundraising rounds.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
