The Paradox of Dilution

Generally people tend to shy away from this incredible ‘D’ word that I hear about every day and is discussed often working at a Venture Fund –

The word being – ‘DILUTION ‘, In all honesty it is even more frowned upon that the traditional ‘F’ word.

But, there is a saying in Marwardi which generally says - ‘Rokde mai baat kar ‘ which translates to

“ Lets talk cash flows “.

I will be coming back to what I mean very soon but for starters, let’s just get to the basics and understand what dilution means.

What is this D word –

Dilution dominantly happens at a financing round for a company. Now let’s assume that you own a ten percentage stake in a company, and your company is worth a 100 million Dollars. If you are in the process of raising 25 Million Dollars at the 100 Dollar Million pre money valuation, then it essentially means that every existent owner of the company gets diluted 20 percent.

From a 10 percent stake you would be going down to a 8 percent stake. CRAP !!!

But recalling the phrase – “ Let’s talk cash ! “, it doesn’t make a difference, at least in ownership value before and after the financing round.

10 percent of a 100 million entity with no cash = 10 Million

 8 percent of a 125 million entity post money = 10 Million

(Note – When we say that there is no cash it is assumed that you and your investor are in a fully trust worthy bond and both parties take decisions best for the sake of the company making decision power worthless. This is a mathematical article focusing on company value in all objectivity and also an option pool is not an assumption in these calculations)

The essence of this calculation being – that you hold similar value of an entity in cash terms before and after a day of this funding event. Every owner also owns their percentage share of the cash infused in the company.

But Financing Events are Misleading……… 

Most people in the start-up ecosystem think of a percentage of their business being sold to an investor. Everyone generally agrees that dilution should be avoided. VCs insist on pro-rata rights to avoid the D word. Executives often complain that they should be ‘made whole’ to offset the dilution that came with the financing event. This is very misleading considering the fact that the cash value of their ownership hasn’t been affected even by a single penny in our example.

Because Financing rounds are generally accumulative –

The ecosystem seems to be a bit confused saying Financing rounds are dilutive in nature. Because financing up-rounds should be considered as value accretion and not dilution.

Simple math being – If you owned 10 percent of a 100 Million dollar entity and there were to be a financing up-round of 25 Million at a 200 Million pre-money valuation :

10 percent of 100 million Dollars   – you’re worth 10 Million Dollars

 8 percent of 225 million Dollars    – you’re worth 20 Million Dollars

Now that’s pretty freaking fantastic. It’s always better to own less of something worth much more than to own a whole lot of something worth much less. Complaining about this is what mad men would do. 

If VCs want pro-rata allocation because they believe in the value accretion, that a fabulous strategy. If executives receive more compensation in stocks because their company has a tremendous value generation capability then – Why the hell not. But if it is done to avoid dilution or if the founders want to be ‘made whole‘ because of the dilution then there’s some serious mathematical issue out there.

Then what is True Dilution and how does it happen….

I come from a very small city called ‘Surat’ and my father runs a business there. If he were to see some of the business financials and strategies startups take up – He will simply say this is not business and please for God’s sake, don’t learn this.

The reason being that while Financing events are where this accretion or dilution shows up, it’s really not happening there. Dilution is much more complex and should not be viewed as an event taking place at a single point in time.

True Dilution = Burn rate – Incremental Business Value generated

And Business value is a function of business cash flows – and hence the saying:

“ Let’s talk Cash Flows “

Dilution will be the factor of how much the company burns in cash and how much incremental cash can a business generate. In simpler words, while it comes out in financing events, it actually happens in the everyday choices that a company makes and the work the company manages to get done.

Even more simply put – If there is more value being generated than the cash being burnt. Congratulations: There is no such thing as dilution for you. And business value is only generated in an enhanced ability to generate better quality future incremental cash flows.

But if you are burning more cash than the value being generated there is a D word right there for you. Put another way, you’re not being diluted because of this financing event but it is because your business is building stuff that the customers didn’t want. It is taking up inefficient growth strategy to scale up the operations and sales. It is because you’ve taken up growth strategies that your business cannot sustain and you don’t want your growth numbers to slow.

The Harder Pill to Swallow

In the recent era of richly capitalized Ventures, there are some highly overvalued companies that are across every sector in essentially the Start-up space. These financings are celebrated because they appear to be minimally dilutive and the company gets a stock pile of cash. Unfortunately, they distort the Marwadi(Cash) equation of business and the results are often disappointing.

Imagine the same company in our example has one of these extreme cash burn growth strategies and the growth numbers suggest a 100 Million dollars at a 800 Million pre-money valuation which is essentially an extrapolation of the same 25 Million at a 200 M pre-money valuation but just that the cash pile is large.

This means that your 10 percent is now valued at 80 million as compared to the previous 10 Million initially. This shouldn’t be a celebration give your cash flows are burning that pile instead of adding to it. Just the magnitude doesn’t say anything about business value or quality. This large transaction will lead to an incremental cash burn and also a lack of cash utilization opportunity considering the growth strategy was ineffective.

Let’s build Businesses that create value and not valuations. Let’s build cash flows and not cash furnaces !

Note – The scenarios created are not what actually happen. This is just a tool, a mental model that aids in enhancing when thinking about dilution and business financing.