Marsh Business Advisors, LLC
"CAPITAL"
Fallacy Of Dilution Clouds The Value Of Venture Capital
By: Stuart Wm. Marsh
President, Genesee Capital, Inc.
March 26, 1993
How do you respond when your banker has turned down your company's request for a commercial loan to fund an expansion or an acquisition?
Screaming, questioning his intelligence, and speculating on various genetic and moral defects in his ancestry might make you feel better, but in all like likelihood will not enhance your chances of obtaining the requested capital.
The more rational approach would be to make the same request to several different banks. If the universal response is "no," then you can only conclude it is not a "bankable" deal.
Now what? Now ask yourself a few tough questions. What is the expected return from your investment project? What is the project's risk? What is the project's risk adjusted cost of capital? The bank said no because the risk was too high. But if your project has an expected return that is commensurately high with the expected risk, then you might be able to attract financing from a venture capitalist.
Most business owners deal with bankers throughout their company's life. But few businesses deal with venture capitalists, and those who have typically deal with a venture capitalist only for a relatively short period.
It is important to understand the process of working with a venture capitalist, especially since the picture has brightened in the venture capital industry, which over the last several years experienced a "capital crunch" far worse than any "credit crunch" in the banking industry.
Venture capital funds raise their investable capital primarily from pension funds, insurance companies and endowment funds. In 1987, venture funds raised $4.2 billion. The amount fell 29 percent to $3 billion in 1988, declined 20 percent to $2.4 billion in 1989, dropped 23 percent to $1.8 billion in 1990, and then fell 28 percent to $1.3 billion in 1991. As the supply of venture capital dwindled, venture capitalists became more selective; the number of investments declined, and venture capital became more expensive.
The good news is that the venture industry last year raised $2.5 billion, a 92 percent increase over 1991. This means more venture money is available, and venture capitalists are actively seeking new investments.
Venture capitalists typically want to generate annual returns exceeding 25percent. A $1 million investment would have to grow to more than $3 million in five years in order to generate a 25 percent annual compounded rate of return.
It would be nice if a venture fund could generate a 25 percent return on each investment, but it doesn't. Remember, venture funds are in the business of taking risks, and the definition of risk becomes clear when you examine the results of the "average" venture portfolio.
Out of every 10 investments made by a venture fund, three will "tank" and become absolutely worthless. Another three investments will become the "living dead" that is, companies that haven'tf ailed,but haven't succeeded and so the venture fund cannot get a return of its capital, let alone a return on its capital.
Two might return the original investment, plus a modest profit. The remaining two investments hopefully will become "superstars" and return 10 to 20 times the original investment. With huge returns from 20percent of the portfolio, modest returns from another 20 percent, zero returns from 30 percent and negative returns from the remaining 30 percent, the venture capitalist hopes to achieve an average portfolio return of 25 percent.
Assuming that the project risk is higher than a bank can accept and that the project returns are high enough to merit a venture capital investment, your first step is to turn to two excellent sources of information: "Pratt's Guide to Venture Capital Sources" and NASBIC's "Membership Directory of Small Business Investment Companies." These provide the names, addresses, phone numbers and investment criteria for virtually every venture capital fund and SBIC in the United States.
After hearing you outline your project over the phone, the venture capitalist either will indicate he is not interested or will ask you to submit a business plan. If your business plan intrigues him, he will call you and request a meeting, probably on your turf. This will give the venture capitalist a chance to size up both you and your operation.
If suitably impressed, the venture capitalist probably will spend the next several months performing due diligence – that is, analyzing your product or service, market characteristics such as its current size and expected growth rates, and management's (that is, your) capabilities of capitalizing on the opportunities and profitability growing your firm.
If the venture capitalist is satisfied your project is a worthy one, he will issue a "term sheet," which is a nonbinding proposal outlining the terms and conditions of his proposed investment in your company. The terms include the dollar amount, type of investment (typically preferred or common stock), price per share, size of the dividend, and any preferential rights such as board representation, conditional control rights, anti-dilution rights, and demand registration rights.
Far and away, the two biggest hurdles for the businessman considering taking on equity are valuation and dilution. A venture capitalist makes an equity investment in your company by buying preferred or common stock. If you think your company is worth $10 million before the investment (the "pre-money valuation") and you need $2.5 million to finance the new project, then you would be willing to sell 20 percent of the newly valued $12.5 million company (the "post-money valuation") in order to raise the $2.5 million. If this were acceptable to the venture capitalist, then after the investment your firm would be worth $12.5 million, and the post-money valuation simply would be the sum of the $10 million pre-money valuation and the new $2.5 million venture capital investment.
Typically, however, there is an argument over valuation; you believe your firm is worth $10 million, and your frame of reference comes from working in the industry and managing your business for a long time. The venture capitalist, whose frame of reference is looking at hundreds of both different and similar companies eachyear, might argue that your firm is worth less – in this example, say, $5 million.
Thus, in order to raise the $2.5 million you will need to sell 33 percent of your company instead of 20 percent. This disagreement over valuation typically stems from the perception of risk; the venture capitalist perceives it to be higher than does the business owner.
Aggravating the migraine caused by this valuation issue is the dilemma of dilution. This occurs when you sell an ownership position in your company, and the percentage of the company that you own declines. Your business advisers might argue that dilution is a terrible thing and that you should avoid it at all costs.
Let me state emphatically and categorically that dilution is a fallacy and virtually all the arguments against it are founded on a false premise.
Let's assume you are seeking $2.5 million, that you and the venture capitalist agree that your firm, before the new investment, is worth $10 million (pre-money) and that your firm will be worth $12.5 million after the new investment (post-money). The venture capitalist offers to invest $2.5 million and will in exchange receive stock representing 20 percent ($2.5million divided by $12.5 million) of your company.
You inform the venture capitalist that you would like some time to consider his term sheet. You decide to stop somewhere for happy hour because that is precisely the emotion you are not currently experiencing. In fact, you feel miserable because you can't stop thinking about the fact that you currently own 100 percent of your company but if you take on this venture capitalist investment you will end up owning only 80 percent. The bartender gives you a sad look as you order another triple martini.
But cheer up! You are looking at the dilution issue the wrong way. Ignore the dilution of the percentage ofownership, and focus on the creation of value. Before the venture capitalist investment you owned 100 percent of a company worth $10 million. After the investment you owned 80 percent of a company worth $12.5 million. Either way your net equity is $10 million. The difference is that with the $2.5 million venture financing you have the opportunity to proceed with the project that should significantly increase the overall value of your firm.
Now let's assume that your project is a success and generates an annual return of 25 percent over the next five years. Your firm now is worth some $38 million, and the venture capitalists' 20 percent share is worth some $7.5million. Before the venture capital investment you owned 100 percent of a company worth $10million. Afterward, you own 80 percent of a business that is worth $38 million, and your net equity exceeds $30 million.
So you tell me, which way are you better off? Were you diluted? On a percentage of ownership basis, yes, but so what? On a value basis, you are much better off. The only time you will be worse off on a value basis is when you take in the venture financing and the project fails.
Although you might bemoan the fact that you failed, take solace in the fact that the venture capitalist shared your losses. But if you believe you will succeed, then go for it. After all, 'tis better to have loved and lost than never to have loved at all.