Dilution during fundraising is a mechanism that needs to be mastered. Advimotion is a financial advisory firm that assists startups and SMEs in obtaining non-dilutive financing and equity fundraising. We also act as advisors in corporate divestiture transactions to best represent the interests of sellers.
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You want to call upon external investors to finance your growth ? This is a necessary step for many entrepreneurs. However, it is advisable to anticipate the dilution mechanism in fundraising. Go for it but don’t forget 2 things in this article.
1- You should always remain the majority shareholder of your company.
Dilution is an inherent phenomenon in any capital increase. The founders of the company see their percentage of ownership of the company’s shares decrease after the fund raising. However, it is recommended that the founders always hold more than 50% of the voting rights of the company. This way, they can keep the power of management and remain major decision makers within the company.
It is also important to note that some so-called “hands off” investors will not want to invest in your company if you lose the majority shareholding. If you are no longer the main owner, your motivation may decrease. However, the main interest of a “hands off” investor is to finance you in order to get out of your capital with its capital gain within 5 to 8 years. Moreover, he does not have to manage the operational or the strategy of your company.
*A “hands off” investor will not want to interfere in the strategic and operational decision making unlike the “hands on” investor.
2- You should always anticipate future fundraisings (if you have any planned).
With each fundraising, you will dilute your capital. If you have planned 2 or 3 fundraisings, you must anticipate the dilution of your capital. It is advisable to always be around 66.67% of the capital before each fundraising. This safety margin is recommended in the fundraising world.
But you should also know that the more funds you are going to raise, the more the valuation of your company will increase and the lower the dilution of your company will be. In fact, in Europe and the United States, a reasonable level of dilution (percentage given to investors) is between 10% and 25% of the capital. Selling more than 25% is very disadvantageous for the founders. Below 10%, your deal shows a strong competition between investors.
3 – Procedures for maintaining control during a fundraising
We present two possible procedures for raising funds that allow you to keep control of your company. These procedures require the prior agreement of the investors.
Raise your funds in several instalments
A first possibility is to carry out several successive fund-raising operations accompanied by increasing issue premiums.
By definition, the issue premium is the difference between the value contributed by the investor and the share of the share capital allocated to him. This device perceived as an “entry fee” to be paid by the new investors who will enter the capital, does not confer to the latter any right on the capital. This procedure aims at protecting the existing partners against the risk of dilution of their participation in the company, linked to the arrival of new partners. This mechanism increases the value of the share premium as the value of the company increases.
Issuance of specific securities, the OCA
Other possibilities are possible such as the issue of bonds convertible into shares (OCA):
This financial tool can be offered during negotiations. The partners and managers of the company retain control of the company because the company first issues bonds which are securities not giving access to the company’s share capital and which constitute a debt that will have to be repaid by the company according to a schedule. This is a flexible contract for two reasons: the investor can withdraw if he does not wish to enter the company’s capital and if the company fails to repay the bonds, the latter are transformed into shares (the quantity of which is specified in a shareholder agreement).
Another possible procedure is the so-called warrants.
This is the opposite of OCAs and the applicable rules are governed by a shareholders’ agreement. In the case of warrants, the investors hold instantly more than 50% of the capital but the founder is authorized to buy back his shares at the end of a period of unavailability, which thus allows him to become again the majority shareholder of the company.
Dilution fundraising: in conclusion
As you have understood, raising funds will help you finance the start-up or the growth of your company. However, don’t forget that the phenomenon of dilution is real and that consequently, you should always remain the majority shareholder. Finally, it is important to anticipate your next fundraising in order to keep control of your company.
If you wish to be accompanied in your fundraising process, call Advimotion, a consulting firm specialized in fundraising for start-ups and SMEs.
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