Dilution: When Less Is More

Notes On The Dreaded Capital Raise

“DILUTION?!? I’m going to own less of this company?”

I see this reaction every time an early stage company does a capital raise via stock issuance. I’m here to dispel some myths and maybe talk you off the ledge.

What’s actually happening

Let’s start with the most very basic example.

Imagine your 7 year old nephew runs a lemonade stand business (ticker: LMON) - currently composed of two lemonade stands - of which you’re a 50% owner. Your nephew, a smart kid, does a discounted cash flow analysis on the business and comes to the conclusion that each lemonade stand is valued at $100. The total business is valued at $200. As a 50% owner, your stake is worth $100.

As an entrepreneurial spirit, he wants to double the size of the business and expand to 2 additional locations. How does he do it? The dreaded capital raise - he takes $200 from his 5 year old cousin, and buys two more stands.

First of all, I don’t know why you’re in business with a bunch of children. But, let’s break down what just happened.

Did you get diluted? Well sort of. He had to double the share count to make this happen (from 2 shares to 4), and you now own 25% of the business (down from 50% before).

But, your share in “business units” didn’t change. Before you owned 50% of two lemonade stands - equivalent to 1 lemonade stand. Now, you own 25% of four lemonade stands - equivalent to 1 lemonade stand.

So yes, you now own less of the company than you did previously, but the company size doubled in the process. Your stake, and resulting cash flows, should be unaffected.

Also note that this doesn’t affect share price.

• Pre Dilution, there were two shares and the company was worth $200 ($100 per share).

• Post Dilution, there are now four shares and the company is worth $400 ($100 per share)

Don’t take my word for it. Here’s some commentary from the Dean of Valuation - Mr. Aswath Damodaran - on this very topic: LINK

And directly from his lecture slides:

If you are doing a discounted cash flow valuation, the right response to the expected dilution is to do nothing.

The aggregate value of equity that you compute today includes the present value of expected cash flows, including the negative cash flows in the up front years.

• The latter will reduce the present value (value of operating assets), and that reduction captures the dilution effect.

• You can divide the value of equity by the number of share outstanding today, and you will have already incorporated dilution.

The problem is when investors think that they own the expansion (or other business phase) that hasn’t been paid for yet. As long as you understand that negative future cash flows have to be financed in some way, dilution shouldn’t concern you.

Issuance Price

In the example above, the fair value for LMON was calculated at $100 per share pre-dilution. However, because of economic uncertainty, the market price for the stock currently trades at $50 per share.

If your nephew still wants to go through with the expansion, he’d have to issue 4 shares to raise the $200 needed to open the new stands.

After the dilution, there are now 6 total shares. Still owning one share, your stake is now 16% - equivalent to 0.6 lemonade stands. That’s down from 1 equivalent lemonade stand in the original example where equity holders were diluted at fair value.

On the flip side, if LMON meme’d its way to $200 per share, a dilution at that price would be a great deal for existing shareholders - management could fund the same expansion with only half the dilution.

Price matters. And as a current investor, you want to see dilution occur at (or above) fair value.

The latter example is why I’m a big fan of At-the-Market (ATM) offerings. ATMs allow company management to dilute quickly in favorable environments without having to perform a registered offering, which take a lot longer to push through, and often can lead to “missing the moment” in the event of a quick spike due to market mechanics such as a short squeeze.

When The Thesis Changes

Dilution should be part of your forecast. If a company expects to burn capital for a while prior to reaching steady-state profitability, dilution is just an expectation.

It’s when the forecast is wrong that you need to be weary as an investor. If the path to profitability starts seeing schedule slippage or unexpected spending crops up, that’s when dilution hasn’t been properly accounted for.

But that’s more of an issue with your projection, and less so to do with the dilution itself.

At any rate, this happens often, and conservatism should be built into your forecasting models to account for this likelihood.

Why Not Debt?

Namely risk.

Imagine that you’re sitting at a blackjack table. You’ve just bet 10-large on a single hand. You flip a 6 and a 5. It’s the perfect setup to double down, but that $10k was everything you had left.

A banker happens to be walking by and gives you two options:

1. Equity: He’ll front you the $10k you need to double down for 40% of your winnings.

2. Credit: He’ll lend you the $10k, and wants 20% interest on that loan - meaning you’ll owe him $12k after the bet is over…win or lose

Here’s what that looks like:

Notice that in the scenario where you borrow money, your upside is better when you win. However, the downside is you still owe the banker his $12k even when you lose. If you don’t have that money in reserves, you’re in trouble - liens get put on your house; kneecaps get threatened by baseball bats.

On the flip side, going the equity route, your upside is capped, but you also can’t lose more than you bet.

The same can be said for high risk entrepreneurial endeavors. Once a company starts taking out debt, a clock starts on when success must be achieved. And if you miss that deadline, lenders start seizing assets and your kids have to start going to public school again.

It’s important to note that this goes far beyond expected value. Even if the math heavily favors the borrowing scenario, business survival is an intangible that is paramount above all else. As long as you survive, you can always try to ante up again by doing another equity issuance.

So when is it appropriate to take on debt?

Once a company reaches a level of maturity where risk of cash flows and timing of cash flows is no longer a concern, that’s when the focus can shift more towards profit optimization.

Strong Cash Balance

It's very hard to go bankrupt when you don't have any debt. ~ Peter Lynch

A strong balance sheet is extremely beneficial in that it offers very favorable risk posture. Maintaining ample liquidity gives flexibility to perform capital raises from a position of strength - the worst time to raise capital is when you “need” it. So periodically replenishing the coffers is often a great strategy.

Most importantly, it gives investors confidence that short term liquidity needs are met. This, alone, lowers the risk of the business which, in turn, results in a higher valuation. And a higher valuation feeds into the ability to raise capital on better terms. It’s all a giant feedback loop that leads to “more cash is better”.

In addition, having cash on hand in times like today, where there are attractive returns on cash, offers another source of income. Having a billion dollars on the balance sheet today returns between $40 and $50 million dollars in annual coupons. This can often be as much as 20% of the annual cash burn rate.

Understand, Don’t Fear

Yes, you’ll own less of the company over time. But dilution isn’t something to fear—it’s something to understand. If you know why it’s happening, when to expect it, and how to model its impact, it becomes a manageable part of the investment journey, not a nasty surprise. Dilution often funds growth, hires talent, or strengthens the balance sheet—all of which can grow the value of your slice, even if it’s smaller.