Lazy Sunday Musings On Dilution

One big topic newer fund managers won’t likely appreciate in the early days is the effect dilution can have on an early-stage investment. I know this because I had no clue about it when I started. Even when other investors would ask me about it, I knew what what it was but I didn’t realize how it would effect me.

The big disconnect here occurs because for many early stage investors, there is no “price per share” or PPS of a company or investment. So many early-stage investments happen to be done on convertible notes or SAFEs, which only “cap” the valuation — there are no priced shares, per se, at this time. Those notes convert during an equity round, usually the Series A, but often newer managers don’t have information rates, back office administrators, or audit requirements that would give them a chance to know their PPS for each investment.

Another reason dilution pops up is because most newer early stage fund managers either don’t know how to manage reserves, or have reserves at all. Without reserves, the earliest investors will suffer dilution with every future equity round, and perhaps even be wiped out in more aggressive recapitalizations. And even with reserves, early-stage managers may not have enough clout or positioning to follow-on into competitive VC rounds. Also, dollar-wise, newer managers may be writing smaller checks into rounds.

So, all of this compounds. As a rule of thumb, I’ve found that in a future equity round, an investor who doesn’t hold pro-rata can expect to be diluted 18% on average. If you were the seed investor via a convertible note in a cool company that’s gone on to raise Series A and B equity rounds and you were not able to follow-on, you have preferred Series A shares (with a PPS) but your ownership percentage would have been diluted by the B round.

Dilution isn’t the end of the world for an angel investor (using his or her own money) or a very small fund (which can get into the carry quicker), but it can be disastrous for funds as small as $10M and up. One way to combat dilution is to invest much more upfront, “to get more ownership,” but that’s very hard to do in seed rounds and most newer managers want to have more shots on goal given the randomness of early-stage investing. Another way is to keep and manage reserves and work to earn the right to keep pro-rata, a topic I’ll write about next weekend.

One lesson I learned the hard way is that, when you start investing in startups, you think in absolutes. You seeded a company with a $250K check out of your fund at a $6M valuation, and the Series B round was done at $96M post-money, giving you a gross multiple of 16x. But, you likely don’t know the PPS for the shares at the A round, or what the compression is after the B round because you don’t have information rights or a back office to parse them. It may be easy to think that $250K check has appreciated 16x, but assuming 18% dilution at the Series B with no follow-on funding, the net multiple would be just over 10x. That’s still great, but if it’s the best deal in your fund and the fund is larger, it can really pinch the fund returns. Hitting a multi-billion dollar rocketship will heal any dilution wounds, but those are tough to come by. Absent one of those, in a world with more dilution, piling in upfront and positioning to invest at least one more time early is the only way to give these early a funds a chance to drive returns.