Any investing entails an element of risk. Early stage investing is a very risky endeavor in comparison to many other asset classes. Of course, the risk is shouldered as the expected returns should be higher than less risky alternatives. The fact is that most early stage companies fail and equity investors stand a good chance of losing all of their money. That is the way it works. Professional investors in early stage companies understand that many of the companies they help fund will fail but holding a diversified portfolio with a few successes will hopefully make up for the many failures.
Even if a young company is experiencing solid financial success, an individual may still be at risk of losing some or most of their investment. Today many young companies will go through a series of funding rounds and, depending on the shareholder rights, early investors may be asked to kick in additional capital into the company. If you do not, your ownership will end up being diluted. This may have a substantial impact on the value of your investment.
Not too long ago, I was reviewing an offering memorandum of a startup raising capital online. The management of the company stated they would need hundreds of millions of dollars more to complete their business plan. Yet they were raising a relatively trivial sum in their first round. This meant the chance for a smaller investor in this funding round to ever generate a significant capital gain was all but vapor. Of course, the company had a cool concept so perhaps a small investment would have been a good topic of conversation at a cocktail party or two. Your money. Your choice.
Now that investing in earlier stage companies is easier than ever before with updated exemptions like Reg A+, Reg CF and Reg D 506c (accredited investors only), it is very important for all investors to make balanced decisions when investing in young companies.
Recently, in reviewing a different Offering Circular (we look at many of these), I was impressed with the degree of detail regarding the explanation of share dilution and what it means to investors. So I thought it would be of interest to paraphrase the explanation a bit.
Dilution can occur in several different manners. The company can choose to raise more equity capital or perhaps use shares as money to compensate employees or other partners. Perhaps some convertible bonds, options or warrants get exercised. New shares mean that even if the value of the company is going up, the percentage of the company that you own may be going down. It can even go down faster than the market value for the company.
Getting a significant dilution can harm the value of your investment. A more punitive event could be a situation where a company experiences a down round. That means they are raising capital at a valuation lower than a previous funding round – perhaps the one you participated in. The share ownership for an investor may drop below their initial investment.
When making an investment in a young company with the expectation to own a certain percentage of the organization on an ongoing basis, you better be prepared to kick more money in. Dilution can impact not only the share ownership but also voting control and earnings per share. The event can coincide to a point where the shares may become effectively worthless.
If you want an example of an extreme valuation shift of a recent, high-profile, private company – just read the story of Theranos. Once upon a time, Theranos held a market value of $9 billion. As their entire blood testing process came into question, some people predicted Theranos could go to zero. Forbes recently valued the ownership of Theranos founder Elizabeth Holmes at nothing. Previously her net worth was estimated at $4.5 billion. That is quite an eye-opening drop. While few of us will ever get to experience such valuation changes, the lesson remains.
Another aspect an investor should understand is that not all shareholders hold the same rights. It is typical that certain large investors hold anti-dilution rights. While these may differ, this provides a certain level of protection that other shareholders may not benefit from.
In closing, if someone is pitching a high return, low-risk investment don’t just walk away. Run. Otherwise, always do your homework, read all of the material provided by the company and understand the risk intrinsic to the investment. If you have substantial concerns, skip it. There will be another opportunity around the corner.