Venture Capital Method - Dilution
When applying the venture capital method, dilution is a prime consideration in making the complex projections for the future. What exactly is “dilution” and how can it be prevented?
The important thing in understanding the venture capital method of investment analysis is realizing that it is pointed toward an exit position. In other words, it is not so important to know where the company stands now. The current picture is going to change drastically anyway when the infusion of venture capital hits its books. What is important is where the company will be, and what will be the venture capitalist’s position in 3-5 years. This type of analysis is very difficult. One factor that must be considered in the venture capital method is dilution.
Dilution refers to the weakening of the ownership position in the company by the addition of new investors in latter stages. If a venture capitalist makes his exit projections based on ownership of, say, 40% of the outstanding stock, but in a later stage investment, this percentage drops to 25% by the awarding of more ownership equity, the investment is diluted. The danger is that this dilution will seriously impact the projections made on exit ROI.
There are two ways that the venture capitalist can deal with dilution in his planning. One is to structure the deal to preclude it. As part of the original arrangement, it is specified that the ownership percentage will never fall below a certain point regardless of the addition of new equity capital in later stages. The other way is to anticipate and plan for it. If it is possible to still reach the exit goals with less equity, the dilution is covered in the analysis.
The idea of company evaluation is as much an art form as a financial science. The future is full of uncertainty. This explains the popularity of a whole new set of analytic metrics. These are new standards of measurement used to study the potential of a target company. Each venture capitalist has to use his own set of standards and metrics to work out the vision of the investment exit up to five years later.
It is not possible to apply this method or anticipate all possible causes of dilution when studying an investment opportunity. If it were easy, everyone would do it and the ROI would match a passbook savings account. This also explains why many foreign venture capital firms are so reliant on outside management. The whole process is very complex and takes skill and experience on the part of the VC to pull it off.