Originally published September 23, 2014
In part 1 of this series, I discussed the first of four rules of thumb for growth company entrepreneurs looking for venture capital investment. In this segment, we are going to examine two of the most important fundamental concepts in venture capital finance:
Rule #2: Understand the Twin Concepts of Dilution and Valuation
Since you will be selling equity (see Rule #1), you will need to become very famil¬iar with the concepts of dilution and valu¬ation. No two terms are used more often and misunderstood more frequently. "Percentage dilution" refers to a reduction in the percentage ownership of a given shareholder in a company caused by the issuance of new securities. "Price (or economic) dilution" refers to a reduction in the per share price of the company's stock based upon the issuance of additional securities at a reduced valuation.
The valuation of a company, or more precisely its "fully diluted, pre-money" valuation (PMV), refers to the value of the equity of the company prior to the new investment assuming that all options, warrants and other convertible securities are in fact converted and exercised for common stock.When investors tell you they will invest at a certain valuation, they are indicating the percentage of your company they expect to own for a given sum of money and accordingly, the percentage by which all prior shareholders (assuming their ownership remains unchanged) will be diluted. In this sense, the concepts of valuation and dilution are mirror images of each other.
In a more nuanced sense, the PMV reflects the price at which the investment is expected to meet the investors' return criteria based on the projected exit valuation (as a multiple of the PMV) and the anticipated time until the exit occurs. From the investors' perspective, the PMV must be low enough (and the exit near enough) to allow the anticipated return to be commensurate with the risk of the investment. In other words, investors will measure your opportunity against the returns available in alternative investments and will tend to choose investments with the highest (and quickest) anticipated returns for a given level of risk.The nego¬tiations over PMV and dilution are merely proxies for this rational decision-making process by investors.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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