Dilution vs. Death

Thanks Laff4K for CC-A photo

I was chatting with a talented and smart founder/CEO in our portfolio about the Series B funding round he is going out to raise for the company, and the subject of dilution came up.

We had a conversation I have had many times: how much money to raise, and at what price. Specifically, he was sensitive to the amount of dilution he would take in the next round of funding. He owns approximately 20% of the company now and thinks things are going well. Ideally the company might raise more money at a $150M valuation, but if the market won’t support that, and offers came at say $100M, his inclination would be to raise a small amount of money and make more progress and go out later to raise at a really big price.

In this case, our interests are largely aligned: our existing investment will get diluted alongside his. It would be very unusual at this stage for us to do more than our pro-rata share of the next round — which would be the only case in which we’d have a financial incentive to argue for a lower price.

However, I disagree on next steps: I believe many founders are too worried about dilution from follow-on “up rounds”, and should be more concerned about running out of money.

Of course, it makes sense to take as little dilution as possible to achieve the same outcome. That benefits all the shareholders, who will own a larger stake in the company when it exits. But we have been in an extended run of good financing markets, and many entrepreneurs have never experienced a down market. It is quite likely over the coming years, at some point, we will be in a time where it is difficult even for good companies to raise follow-on capital quickly and at good prices. It is possible we will be in a time where it is difficult even for good companies to raise follow-on capital at all, at any price.

If the founder were to, in an extreme scenario, raise $20M at $100M pre-money, instead of the ideal $20M at $150M (a drastic price cut). The founder’s ownership would go from 20% to 17.6% in the good case, or to 16.7% in the bad case. In what outcome is this super important? If the company gets bought for a billion dollars, are you really crying over having $167M vs. $176m? If the company has a “bad” outcome — say sells for $100M — after paying preference the difference is $12.4 vs. $11.7 to the founder’s pocket. Real money, no doubt, but the difference is not life changing in any way. Even when you stack on more dilution later from Series C/D, the impact between these two prices in this round today is small, and in either case, the founder is financially set for life.

You know what would be a bad outcome? The company going out of business. That is compoundingly bad for the entrepreneur: his payout in either case would be zero. Plus, his probability of success in the next venture are lowered both because he will not have a reputation as a winner, and because he will not have the F-U money in his bank account to take risks and be patient for a big opportunity.

When you have reached this scale and the stakes are this big, all the leverage is in the size of the eventual exit, and maximizing the probability of winning (and minimizing the probability of a washout). Actual changes to ownership from up round financings will not be the high-order bit. (Down rounds with antidulition provisions are a different story).

There’s only one way to go out of business: to run out money. With a smart team in a big market, if you can stay alive long enough, good things will happen.

My advice is to raise the right amount of money for the company at this stage, even if the price is disappointing. If you quickly outperform that price, I promise you will be too happy to hold deep regret over the point of ownership you lost. If you raise the round skinny to just get you to the next milestone, that extra point of ownership will be no comfort if your company stumbles, or the macro environment tanks, and you’re stuck staring at that red light on the dash next to the big “E” on the gas gauge.

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Written by Josh Hannah
Josh Hannah joined Matrix Partners after a career as a serial entrepreneur (Betfair, eHow, wikiHow.) Read more about Josh.

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