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HomeFinance and AccountingBusiness InvestmentWhat is dilution and how can it affect investors?

What is dilution and how can it affect investors?

As a startup grows, both its needs and its relationship with investors also change. One of the situations that occur during this evolution occurs when the start-up company launches in search of more investment, which is known as dilution. In this situation, many companies need some help from professional services like Mars Capital.

It is the “action or effect of diluting”. Indeed, dilution occurs when the ownership of a startup’s investment partners is diluted, decreases, as a result of a capital increase.

A priori, the most logical thing is to see this situation as a detriment to the current partners of the project, something that should be avoided at all costs.

Not surprisingly, who would want to see how its shareholding percentage decreases? However, neither its causes nor its expected consequences always have negative effects for the partners of a startup.

What does it consist of?

To exemplify the concept of dilution, nothing better than imagining the ownership of a startup as a cake. When, when the time comes, the needs of the project require more financing, the possibility of a capital increase is considered: the size of the cake is increased so that others can get a portion (in exchange for their corresponding investment).

When this enlargement of the size of the cake occurs, two scenarios can occur. On the one hand, those investors who already have a part of the property can choose to buy a certain amount of the new shares with the intention that their percentage does not decrease as a result of the entry of new investors. However, if he declines this possibility, the former investor will see that, as the size of the cake increases, the percentage that his slice represents is now smaller.

Thus, dilution can occur in two ways: because some of the old partners make a new contribution and the percentage of those who do not participate in the capital increase decreases, or because new shareholders enter the company. In any case, the cause and the main consequence coincide: the startup needs financing and, to obtain it, those who were already involved with the project give up a part of their ownership.

How is it calculated?

When investors can calculate in advance how much their stakes in a startup will be diluted as a result of the entry of new capital, two concepts must be taken into account, mainly: the premoney valuation and the post-money valuation.

On the one hand, the premoney valuation is the value of a startup before it receives a new capital investment. Rather, the post-money valuation is simply the value that that same startup has right after that funding round. In fact, the difference between one valuation and another is nothing more than the investment received.

When calculating the dilution itself, it will be enough to recalculate the percentages of shares that each one owns, taking into account the post-money valuation and the money that comes in. Thus, for a startup owned by three partners with a premoney valuation of 500,000 dollars and a capital increase of 100,000 dollars by a single external investor, the calculations would be as follows:

– With the capital inflow, the postmoney valuation amounts to 600,000 dollars ($ 500,000 + $ 100,000).

– The investor who has provided the financing will be made with just over 16.6% of the startup’s shares ($ 100,000 / $ 600,000), the percentage that their investment represents of the total post-money valuation.

– The other three investors, who each owned 33.3% of the startup’s shares ($ 166,667 / $ 500,000), give up a part of their percentages to make room for that new 16.6%: each will see how their This fraction falls to just over 27.7% of the company ($ 166,667 / $ 600,000).

Does it have negative effects?

Dilution brings with it a handful of benefits and a few minor drawbacks, but if everything goes as expected, it’s not a bad thing. The obvious disadvantage is that part of the control of the startup is lost, but in reality a percentage is transferred for a good cause: with the new capital increase, the project will be able to be developed further and will be revalued. Thus, the piece of the cake will be smaller after the capital increase, but will still be worth more than the portion we originally had was worth.

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