When you open an equity crowdfunding website, you will find a bunch of disclaimers. One of which will always address the risk of dilution.
But what is dilution?
Let’s take a look at an easy example.
A business has 5 shareholders and each one of them owns one share of the company. Assuming that each of them has voting rights, it means that they each have 20% control of the company.
Subsequently, they decide to issue 5 new shares with the same voting rights. If an external investor buys them all, the new investor will have 50% of the 10 total shares outstanding. In other words, the new investor will own 50% of the company and the control of the old investors will be diluted to 10% each.
This process can happen multiple times with significant consequences on the original shareholders.
Equity crowdfunders! Watch out!
The risk is quite real for you to get DILUTED at any point!
Have you watched the movie The Social Network? Do you remember the ‘poor’ Eduardo Saverin in the Facebook story? He invested his money in Facebook along with Mark Zuckerberg at the very beginning and originally owned 30% of Facebook’s shares. However, Mark was not very happy with Eduardo’s commitment and he got rid of him. Unfortunately for Eduardo, his shares had no voting rights, no pre-emption rights or any kind of right on the brand. With a quick series of funding rounds, Eduardo found himself with 0.4% ownership of Facebook. He had been diluted.
Don’t worry! Eduardo’s story still has a happy ending - the poor man earned ‘only’ 4 billion dollars! But remember, Facebook is a unicorn, and most of your investments will not generate such a return.
There are several factors that could dilute your shares in a company:
It is very common for startups to go through multiple series of investment rounds to raise capital in which case the company issues new shares. At that point you as a shareholder can either buy them by means of investment or you will be diluted.
Conversion of Optional Securities
Usually companies have an allocated portion of stock options granted to individuals, such as employees or board members, that if converted to common shares can water you down as a shareholder. Therefore, check what will be the value of your shares if the startup you are investing in has such plans.
Shares as Currency
The shares might be a form of currency to pay out in services or offered for acquisitions.
Small enterprises are constantly looking for funding as they grow, and when ready to scale up, they will attract serious money from VCs who will ask for preferential terms. Pay attention to what is written in the terms and conditions, regarding your newly acquired shares, stated in the details of the crowdfunded deal. Your expectations might not be met due to the effects of #dilution!