Why investors get upset with dilution?
Can someone explain to me why investors get upset/stock tends to drop when additional equity is raised? From a purely mechanical perspective, as long as the stock offering is at the same as the current market price, shouldn't the dilution be completely offset by the increase in cash/market cap when the equity is raised? For example, $1,000,000 market cap with 10,000 shares ($100/share) issues 2,000 new shares at $100/share. Current owners are diluted by 20% but theoretically shouldn't price per share remain constant (now a $1,200,000 market cap with 12,000 shares -- small piece of bigger pie)? Yes I understand usually secondary offerings are often a bit below market price so dilution might be a concern there, but why are investors upset if the offering is at market price...
Because additional equity that’s raised, all else constant, doesn’t change fundamental valuation. If you’re diluted as a shareholder and valuation stays constant, your theoretical value per share, by definition, falls. Look at AMC – diluting their equity numerous times over via ATM raises. Short interest and WSB/retail hype aside, the equity is likely worth 0 and should be trading at de minimis levels (obviously not trading on fundamentals right now, but logically should be).
But my point is technically the cash offsets the dilution. Equity value includes cash...
I mean, dilution in of itself is defined as a reduction in shareholder value without a net increase in assets. So your title is misleading relative to the outcome you're describing.
Shares can be raised at a different pre-money valuation than what previous investors invested at. If I invest in a couple to get 10 shares out of 100 total for $10 each, it would indicate the company is worth $100. But if someone comes in and is able to get 10 new shares (so the new total is 110) at $7.50 a share that would indicate the company is worth $825. The second investor paid only $75 to get what is now 9% of the company but the first investor had to pay $100 for what is now pro-rata the same share %. Furthermore, the total valuation of the company went down from the first round, which indicates that the first investor's investment has actually eroded in underlying value
In a more practical setting, there are usually multiple seed rounds in VC, with the notion that pre-money valuation should continue to rise with each seed round as the company is de-risked (first prototype, first to market, patent, etc). Would you refer to this as dilution just because the company is raising money? No. Would you refer to it as dilution if pre-money valuation was the exact same in the second round as in the first? You wouldn't because they would effectively be the same round at that point. Ultimately, the goal would be for investors to exit with their warrants/prefs at IPO/merger where they all get to cash out at what should be a premium to all shareholders
Again, i'm just talking about with secondary offerings after the company is public. Company issues additional shares at market value --> Stock (usually) drops. I'm just saying that it seems (theoretically because obviously there are many exogenous factors at play such as why is the company raising additional capital in the first place) that issuing new shares at the current market price should not result in the stock dropping because market cap should increase by the same percentage as the shareholders are diluted, all else equal.
Hi,
I read your topic about investors getting upset with dilution. It happens because it reduces their voting power. Diluted earning is a way to value a share after convertible securities have executed.
1. Do the math for primary issuance at lower valuation vs current valuation. Assume issuance at 10$/share vs your example of 100$/share to see how detrimental it is to your entitled earnings. This happens a lot in growth companies where management team gets rewarded by stock option. Thus, for growth companies, a cap on stock option for management team is a common clause in contracts
2. When you invest in a company, it is often the case is that you expect the company to have higher valuation in the future. Thus, higher % ownership means higher potential return. One can always argue that additional funding can help the business to grow faster i.e bigger pie in the future, but a counter argument on diminishing return of additional capital also holds true
3. Certain investor rights got dropped as % of ownership in the company reduced to a certain level - on both regulatory and contractual terms
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