Getting Zavy - the DNA of Capital: Dilution; Notching-up, and Active Investment

Despite a reasonable global ranking in Mathematics and English, New Zealand hasn't taught its investors very well, if at all.

As I am a director of Crowdsphere, and as our goal is to democratise Private Equity, maybe I should teach you some finance stuff, pretty well no one else will.

Like always, I will attempt to illustrate my points with real life examples. In this case the Zavy series B Crowd round.

DILUTION FOR BEGINNERS

Last year Zavy raised its first external capital round, it raised about $325,000, currently, it's raising a second round to assist market growth in Australia. This round is expected to be for a minimum of $300,000 to $600,000, and is scheduled to close in March 2019.

Originally, Zavy had a million shares on issue. Series A was issued at $2per share, meaning 162,500 shares were issued. The previous corporate owner TRA was then diluted from owning 100% of the original shares as it now owned only 1m/1.1625m or 86.02% of the shares.

Likewise, if $600k (the maximum) is raised in this Series B round, that's another 176,470 shares being issued, meaning all of the old shareholders, including TRA and now the Series A round investors will end up owning exactly 86.8% of what they did before. If it's the minimum amount of the raise, then it's 88,235 shares or a dilution to 92.9%. To use TRA as an example, it would own just $1m/$1,338,970 or 74.68% if the maximum is raised.

So is dilution good or bad? Well frankly it depends, if the business is in trouble and it's issuing at a discount: a so-called down round, then it's a nasty brutish thing, with only the survival of the firm being a positive outcome.

Indeed, even if it's a planned money up round, like this one for Zavy, if you're a control freak it can be bad: but it can also be very good for the value of your shareholding. For example, if you value the Zavy shares at the average of the last round and this round ($2 + $3.4)/2 = $2.70, this means that the benefit of your dilution is a 35% increase in the value of your shares. In this case, even if the round closes at the maximum level and your shares are diluted by a full 25.8%, the lift in average value outweighs the impact of dilution!

In the final analysis dilution is just well inevitable! Unfortunately, as the Issuer seeks to raise capital to grow, dilution is unavoidable, however, good Board's will look after shareholders interests by offering them anti-dilute protection via an exclusive investment period protects their interests. It's then in their camp to decide whether or not to invest.

So how much do you need to invest to avoid dilution? Well thankfully not too much.

For example, if you had invested $40,000 previously (20,000 shares or a 1.72% stake in Zavy) and you wanted stay at 1.72% and the maximum amount was raised, then you'd need to invest enough to get 3,030 shares or $10,302, about 25.8% of your original investment. When you use anti-dilute protection coupled with the value lift it's a good thing, as we will see below.

Ok, so what is the impact of investing at the new higher price on my existing shareholding.

NOTCHING UP

Notching, ratcheting, or dollar cost averaging, is a well regarded strategy to access all forms of investments.

Its use in long run savings like superannuation or KiwiSaver, or other retail funds is well known. However, its use across early stage investments like Crowd rounds, Angel investing, or even VC investing, is not well understood.

Unlike value investing in mature liquid listed securities, where fundamental financial analysis could lead you to form a view on investment appetite quite different to Mr Market, and then use these market weaknesses to buy more securities at a lower price.

Whereas, early stage and growth companies tend to initially issue at lower prices, and later as they grow faster, have better cash run ways, approach breakeven, and reduce volatility, they issue incremental capital at higher, and higher prices, the trick here is to ensure that the overall investment stake is of a average lower cost than the last round.

Again let's look at Zavy: originally if you invested $20,000 to get 10,000 shares, if you choose to buy say $4,998 worth of shares at the Series B issue price of $3.40 per share or 1,470 shares then your average share price is: $2.18. If you think that Zavy is good value at $2.18, the average price of your total stake in the Company, then you would invest. This is dollar cost averaging, notching up, or ratcheting up the value of your holding.

You must however, be careful not to go too mad. For example, if you had invested $5,000 at the Series A price of $2, I would not generally invest more than twice that amount in the new round. Why?

Well you're reducing your margin of safety.

What I mean by that is if you had bought $10,000 worth of Series B it would represent 2,941 shares in addition to a $5,000 investment in Series A, the 2,500 initial shares and the 2,941 shares give shares gives a total holding of 5,441 shares with an average value of $2.76. So this is still well below the current issues price, so why would you limit yourself?

Well frankly, it's because your limiting your capacity to be diluted in a future down round. At $2.18 you can suffer a set back in price of 36% before starting to make marginal loses: at $2.76, the margin of safety is down to 18.8%.

Remember all early stage equity investments are risky, never invest more than you can afford to lose. And if you don't like losses then unlike the bubble blowers out there: bloody well get to grips with valuation issues. And always, always, always, look for a margin of safety.

ACTIVE INVESTING

For some of more value minded amongst you, I have set out below a very brief table, highlighting some key metrics for you to consider about the current Zavy offer:

The metrics are: Customers are up 87.5%; ARR is up 136%; Staff up 200%; Cash up 1,100%, and share price up 70%.

So is it good value? Well yes, the ARR to pre-money on the series A was: $2m/$220,000 or 9.09x, and now the pre-money valuation on the series B is: $3,953,000/522,000 or 7.6x - so yes in some respects it's even cheaper than the last round!

If you want to chat through any of this get hold of Ollie Cuthill, Hamish Brimble or myself.

If you are minded to invest in Zavy please commit at https://crowdsphere.co.nz/. 

Also please make sure you check out the Zavy election site: https://elections-zavy.co/