Clipped Wings: The Dramatic Effect Of Dilution On Angel Investing

Right Shark With Wings

If you read my post about equity crowdfunding a few months ago, you know I got a little carried away.  I mean, I was happier than a left shark on Super Bowl Sunday when I found out little guys like you and me can now actually invest in small startups like real life angels (way overdue, in my opinion).

left-shark

But I’ve mellowed out a little bit since then.  I’ve dug into the details on some of the realities of angel investing.  And I’m sorry, fellow angel investors.  I’ve gotta clip our wings.  We’ll, maybe just a nip here and there.  Just enough to bring us back down below those puffy white clouds.

I’m still excited about equity crowdfunding and all the possibilities of investing in startups.  I just need to dial it back a notch and temper expectations.  One big reason?  The downer of…

… Equity Dilution

In my equity Crowdfunding article from December, I glossed over dilution on my way to declaring, you too could become a multi-millionaire from a $100 angel investment.  I didn’t exactly ignore equity dilution.  I just kind of mentioned it in passing then swept it under the rug like it was no big deal.  It happened when I talked about Facebook as the shiniest of shiney examples of the greatest of all angel investment windfalls.

I said this (pay special attention to the bold print.  It goes by fast):

Imagine discovering the next Facebook and getting in on the “ground floor” long before it becomes a $345 billion company…

Yeah, you could have bought stock right around the time Facebook went public and made a nice 4X return by now.  But, if you could have invested even $100 at a $10 million valuation way before Facebook’s IPO (and not gotten diluted along the way), you’d be a multi-millionaire right now!  A little bit of an oversimplification, but you get the idea.

A little bit of an oversimplification?!  Uh… Yeah!  There’s something I forgot to mention there.  Getting “diluted” as an early-stage angel investor, is pretty much a guarantee.  And dilution is a more significant drag than I gave it credit for.  It’s one of several reasons you or I will not become a multi-millionaire from a minimum $100 crowdfunding investment alone.

Easy To Overlook For The Big Headline

In fairness, I’m not the only one that overlooks dilution.  It happens to the very best of us.  In this 2012 article, written right around the time Facebook went public, CNN Money seems to imply that Facebook’s first big investor, Peter Thiel, cashed out his initial $500,000 investment for more than $1 billion.  That’s a staggering 2000X return right there!

What they didn’t mention in the article is that Thiel participated in several different investment rounds before Facebook went public.  He, along with his partners, pumped millions of dollars more into Facebook to build an ultimate equity stash of 44 million shares.  And, I’m guessing a good portion of the 36.8 million shares he sold off post-IPO for more than $1 billion were probably bought after his initial $500,000 investment at a much higher valuation.  I have no doubt he earned a gigantic return on his initial $500,000, just probably not 2000X, like the article implies.

The Realities Of The Ravenous Start-up

You see, startups like Facebook eat capital at a crazy rate.  They need to be constantly fed to grow quickly.  So, they raise round after round of ever-increasing piles of investment money and give away piece after piece of their company.

If early investors, like Thiel, aren’t constantly buying more and more shares of the company in the later rounds, they can easily see their percent ownership of the company get cut to a quarter of what it once was (or much more).  So, not only was my “$100 angel turned multi-millionaire money-boss” example an “oversimplification”, it was probably as close to impossible as impossible can get.  Even in Facebook’s case.

Wigglymug, though… It’s the next Facebook!

Allow me to illustrate the power of dilution.  I’ll use hypothetical, big, round numbers that are way out of my league to make things a little bit more clear.  Don’t worry, it’s still a happy story.  Dilution happens to be a necessary evil when it’s used to get the needed money to grow the overall company really-big-huge for everyone.

Imagine you are already a money-boss, and you invest $500,000 for a 10 percent stake in a promising young tech startup called Wigglymug.  You are Wigglymug’s first outside investor.  You are in baby!  In on the ground floor!

By investing that money, you are saying Wigglymug is now worth $5 million and you think it could be worth much more in the future.  The founders sell you 100,000 shares at $5 each.

1 year later…

Things are going great for Wigglymug.  They are doing great things with your $500,000, but have burned through it pretty quickly.  Wigglymug needs more money to fuel their rapid growth or they’ll flame out.  The founders will have to give away more pieces of their company to get it.

Wigglymug creates 250,000 new shares to sell to an interested venture capital firm.  Wigglymug is now cut into 1.25 million little pieces.  Each share of the company now represents a smaller slice of the Wigglymug pie.  In fact, your 100,000 shares now represent only 8% of the company.

You’ve been diluted, fool!

Here’s the good news…

The new investors pay a higher price per share than you did a year ago.  They are excited by the 10 million wigglies now on the platform that wiggle, on average, 10 times a day.  That’s 5 times more than the year before!  They think Wigglymug could now be worth as much as $10 million and are willing to buy in at that valuation.  The new investors are willing to pay $8 for each of the newly issued shares.

Even though your initial 10% stake in the company has been diluted down to 8%, each of your shares is now, on paper, worth much more than the year before.  So, your initial investment is still worth a lot more, just not as much as if you still owned 10%.  Your stake is worth $800,000 instead of $1,000,000, because of equity dilution.  And, on it goes…

Diluted_1
DILUTED
Now, let’s say you’re a money-boss-super-shark-nado that everyone is afraid of, and you somehow negotiate terms that protect your shares from ever being diluted.

Better yet, let’s say you live in a magical world with your best buddy GLADYS…

gladys

Sorry, I needed an excuse to bring back GLADYS.  I love GLADYS…

So, you live in this magical world where every small startup blossoms into a unicorn with hardly any outside help.

In that pretend world you didn’t get diluted at all, because Wigglymug didn’t need any more investors to grow itself to $1 billion.  And Wigglymug didn’t need to lure young talent with stock options (I forgot to mention, that’s something else that can dilute your stock).  People just wanted to work there for pennies, because…. well, it’s Wigglymug.  Here’s how your returns might look…

Non-diluted_1
NON-DILUTED
See the difference?  A 26X return when your shares are diluted versus 200X.  Don’t get me wrong, 26 times your initial investment is still an obscene return for any investment and any angel investor would consider that a home-run success.  It’s just not quite as life-changing as 200X.

As a matter of fact, here’s a chart of actual angel investing returns from a TechCrunch article a few years back.  Returns greater than 30X are extremely rare in the angel investing world:

wiltbank_angel

The Bottom Line

So… NO.  You won’t become a millionaire by investing just a hundred bucks in an equity crowdfunded startup like I implied in my last article.  Sorry, guys.  Didn’t mean to get your hopes up.  You can probably lop off one of the zeros from even your highest expectations.  Equity dilution keeps us tethered to much more realistic returns.

Maybe I was naive to largely ignore equity dilution in my initial excitement.  I was aware of it and knew it made a dent in overall returns.  I just didn’t know how much of a factor it actually was in angel investing, until I did more research and started doing the math.

Yeah, dilution is a little bit of a reality check.  But it won’t keep me from taking a swing or two at being an angel.  It’s still a huge opportunity if you get a hold of that rare company that happens to make it big.  And I’m just happy to be in the game.

Are you as excited as I am about equity crowdfunding?  Did I teach you anything, or was the full impact of dilution on startups pretty obvious to everyone but me?  I’d love to hear your comments below (even if it’s just to correct my math).

And remember, investing in startups is risky.  Please do your own research before deciding what to do with your money.

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One comment

  1. […] All true.  But, before Reg CF, most retail investors had zero chance to hit that kind of grand slam.  Yeah, you could have bought stock right around the time Facebook went public and made a nice 4X return by now.  But, if you could have invested even $100 at a $10 million valuation way before Facebook’s IPO (and not gotten diluted along the way), you’d be a multi-millionaire right now!  A little bit of an oversimplification, but you get the idea.  Actually I oversimplified this a lot.  Dilution is a significant factor that dramatically affects early investors’ returns.  More on that in this followup article. […]

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