If my students at Cornell University take away one thought from the entire semester of instruction, that thought is embedded in the following exposition:
First, I draw on the blackboard an inverted bell shaped curve, the top of the curve heading downwards rather than up. Then, I remind them of the old saying in the commercial real estate business: "There are three rules for making money in commercial real estate and they are Location, Location, Location." I then migrate that old joke to the venture capital business. "There are three phenomena that trivialize even the best of investment strategies: Dilution, Dilution, Dilution."
Thus, the point of the inverted bell shaped curve is simple enough. Take a sample of one hundred venture-backed companies that have been successful enough to undertake an initial public offering, and you will find a disturbing fact lodged in a high percentage of their prospectus disclosures. That is, the earliest stage investors (the founders and angels) hold very small equity percentages and garner similarly small returns on their investment in the company. One would think that these investors are entitled to the lushest rewards because of the high degree of risk accompanying their investment, but that is not the case. The problem is, of course, dilution. Most early stage companies go through multiple rounds of financing, and one or more of those rounds is often a "down round," which entails a disappointing price per share and, therefore, significant dilution to those shareholders who are not in a position to play in the round.
The problem of dilution is serious, since it has a dampening impact on angels and others who are thinking of financing, joining or otherwise contributing to a start up. Indeed, this is one of the reasons that Universities have not been particularly successful in exploiting the technology they develop in their labs by taking equity in the companies licensing the same. By the time the liquidity event rolls around, the institution has, as often as not, been burned out just like the founder. There is some research that indicates the typical founding group winds up with roughly 8% of the company when the IPO goes effective. This is not chopped liver, but it is a percentage that suffers by comparison to the employee option pool, for example.
There is no ready and obvious fix for this problem. Getting the founder to bring the company to cash flow break even at an early stage, thereby avoiding the necessity of the Series C and D round, is obviously of importance; but that chore is easier said than done. For founders who are also part of the management team, participation in the employee option pool is of some help. Often that participation is eschewed by the founder on the theory that he or she already has enough stock; but I routinely counsel against that assumption and try to get as many of the founders as possible into the option pool whenever possible. In this ugly climate for financing, there is not much else the founder can do except to keep the burn rate low, make cash flow break even as early as possible and hope that the climate improves so that succeeding financings are at prices which are accretive rather dilutive.
Dilution - Dilution - Dilution
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
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