Dilution Protection

  

Okay, we are inside of the beaded walls of StartUpVille and there’s a disagreement revolving around the vision that two parties see in their crystal balls. The founder: Rose Colorglasses, the visionary behind Brain Planes, her telepathically controlled flying car company. Her vision of the future? Flying cars everywhere in just two years. She thinks that her first round of investment capital is a bargain at a dollar a share…and she is certain that the next round of investing—which she expects to happen in two years—will be at 10 dollars a share.

So that’s the vision of Rose Colorglasses…very fast uptake in demand for telepathically controlled flying cars, no big regulatory hurdles…no major accidents, and no headaches. But the vision of Manny Milesonhistires is very different. He thinks that the dollar a share he’s investing at is a gift—way too rich; it is a very high price to pay for a stock with zero proven track record. Manny believes the long term vision that telepathically controlled flying cars are the future...he just believes that it’ll take longer for the masses to adopt this new way of doing things and iron out the bugs.

Manny thinks that Rose will miss all of the financial projections she has made on her projected income statement. Normally he’d just wait until the next round to then invest likely at a cheaper price, but he knows that if he doesn’t invest now, he’ll be iced out of the next round, which he thinks will be at 50 cents a share. So to protect his shareholders—the people who gave Manny the money to invest on their behalf in the first place—Manny gets an anti-dilution provision in his contract. That is, he invests at a dollar a share to buy ⅓ of the company. A million shares. A buck each.

Then time passes. Doo doo doo doo doo doo doo doo. Sure enough, cars do crash in to trees. Cars crash into each other. And well, texting and driving? Very bad idea. And of course, Rose is forced to do the next round of funding...sheepishly at 50 cents a share. If there were originally two million shares of common stock that belonged to Rose as the founder, and Manny bought one million of them for a dollar...with the company now raising 1.5 million dollars at 50 cents a share, the company would have a total of six million shares outstanding.

The original three million shares in the first round, plus three million shares now at 50 cents each. But Manny originally bought ⅓ of the company for his million bucks for a million shares. Manny still owns the million shares he bought at a buck each, only now his ownership stake has been massively diluted. He owns one million out of a total of six million shares outstanding...or ⅙ of the company—way down from the ⅓ he originally bought.

His current stake is roughly just 17% of the company. So his anti-dilution provision kicks in and his original million bucks gets essentially re-priced to the 50 cents that the new round was set for.

So what happens? Well, basically he is issued more shares to “true him up” to owning ⅓ of the company again. He had bought a million shares, owned one out of six million, and to be undiluted, he needs to own two out of six million. Or said another way, Rose is forced to print more shares to give to him so that he owns ⅓ of the company. With this second round, the company has six million shares—if another million is printed and given to him, then he’d own two million shares—but there would be seven million shares now outstanding.

So…depending on how brutally the antidilution contractual language was written, Rose might have to print even more shares to cover his anti-dilution clause. And note in all of this just how much Rose has now been diluted: from owning 100% of the company the day she started it…she now, after just two rounds, still owns her two million shares that comprised all of the company at the beginning...only now there are some seven million plus shares outstanding, and likely many many more to come.

Of course, none of this'll matter if the flying car biz doesn't take off…or maybe takes off a little too quickly, if you catch our drift.

Related or Semi-related Video

Finance: What is Dilution?77 Views

00:00

finance a la shmoop. what is dilution? ownership is a pie.

00:08

here's 100% of pie. it's divided into 20 million slices, there there you just [man holds pie]

00:14

can't see them. each is a share of ownership in the company whatever.com

00:18

well one day the CEO of whatever.com decided she wanted to buy her hated

00:23

competitor something.com for 2 million shares. then she wanted to buy her

00:28

marketing vendor sell my butt off.com for a million shares. well her stock had

00:32

been trading at 12 bucks a share for a total market valuation of 240 million

00:37

dollars .see we get that 12 times 20 million. but then after printing 3 [equation]

00:42

million more shares to buy her competitors,

00:45

well she now has 23 million slices of pie .and yes that's how it works!

00:49

companies can essentially just go to the Xerox machine and print shares of their

00:53

own stock, that they didn't formerly own. but now she has 23 million shares [printer prints shares]

00:57

outstanding and not 20 million. so at $12 a share the stock market is valuing her

01:02

company at a meaningfully higher price. 12 times 23 million is 276 million. it's

01:07

saying that the value of the three million share dilutions she took in

01:12

buying something dot-com and Sell my butt off.com [woman waves to camera]

01:16

was the difference between the 276 million in the 240 million or 36 million

01:21

bucks. but let's say the market value had stayed flat at 240 million. well now with

01:26

23 million shares out the stock is only worth 10 dollars and 43 cents a share,

01:30

instead of the previous $12 a share. in other words shares have been diluted

01:37

each share of whatever com is no longer worth as much as it used to be. that pie

01:42

isn't looking quite as appetizing now is it? [man frowns in kitchen wearing apron]

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Finance: What are anti-dilution provisions?
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What are anti-dilution provisions? Often seen in venture capital and developmental stage companies, anti dilution provisions refer to subscription...

Find other enlightening terms in Shmoop Finance Genius Bar(f)