Dilution is a crucial concept in the context of capital raising according to former head of investment banking for National Securities Corporation and B. Riley Securities Jonathan Rich, particularly for companies actively seeking funding and one of if not the most important consideration by founders, stakeholders and prospective investors alike. Dilution occurs when a company issues new shares, leading to a decrease in the ownership percentage of existing shareholders. Existing investors are willing to exchange dilution and lower ownership as a result in order to deploy raised capital accretively in an effort to continue to grow the overall value of the company, making it worthwhile to own a smaller piece of a larger, more valuable enterprise. New Investors in turn want to know that the shares they are acquiring are being purchased at a fair value and that in turn, the company will use the funds to create larger future value for them and all stakeholders alike.
Jonathan Rich, former head of investment banking for National Securities Corporation and B. Riley Securities believes that the importance of dilution in capital raising can be understood through several key points:
- Access to Capital: Dilution allows companies to raise additional capital by issuing new shares and ownership stake(s) to investors. This is often necessary in order for the company to grow and for funding expansion, research and development, acquisitions, capital expenditures or other strategic initiatives. Without the ability to dilute ownership through issuing new ownership stakes, a company might struggle to access the necessary funds for growth.
- Risk Sharing: Dilution is a way to share the risk and responsibility of the business with new investors. By bringing in new capital, a company can benefit from the expertise, network, and resources that investors may provide. This can help the business navigate challenges, bring in like-minded new stakeholders and increase the likelihood of success through a broader, more diverse investor base and a better capitalized business.
- Valuation and Pricing: Dilution is closely tied to the valuation of a company. When new shares are issued, they are sold at a price and valuation that is determined through a series of analyses and agreed upon by the company and investors, which determines the overall valuation of the company. The valuation is a key factor in negotiations with investors and affects the overall terms of the investment as the larger the valuation agreed upon, the lower the dilution is for the same dollar amount investment had the valuation agreed to been lower. Conversely the lower the agreed upon valuation is, the more dilution is incurred on a dollar equivalent basis.
- Employee Incentives: Many companies use equity-based compensation, such as stock options or restricted stock units, to attract and retain talented employees. Dilution is a natural consequence of these equity-based incentive programs. It allows companies to share ownership with employees, aligning their interests with those of the company.
- Market Perception: Dilution can influence how the market perceives a company. While raising capital is essential for growth, excessive dilution can lead to concerns among existing shareholders about the impact on their ownership stakes. Striking a balance between raising capital and minimizing dilution is crucial for maintaining investor confidence.
- Future Funding Rounds: Dilution in early funding rounds sets a precedent for future rounds. Investors in subsequent funding rounds may consider the historical dilution and its impact on their potential returns. Companies need to carefully manage dilution to ensure that future fundraising efforts are not compromised.
- Liquidity and Exit Strategies: Dilution can also affect the potential returns for shareholders in the event of an exit, such as an acquisition or an initial public offering (IPO). The ownership percentage at exit determines the financial outcome for investors, and dilution plays a role in shaping this outcome.
In summary, according to Jonathan Rich, formerly head of Investment Banking at National Securities Corporation and B. Riley Securities, dilution is a trade-off that companies make to secure the capital needed for growth and development. While it is a common and necessary aspect of fundraising, managing dilution effectively and communicating its implications transparently are crucial for maintaining trust and alignment with existing shareholders.