Stock Dilution in a Startup

Let's say, for example, that you signed up to be COO of a startup company and the CEO founder offered you 5% of the company. The CEO says there's no funding in the bank yet, so you'll have to sign up for a low salary -- $50,000 per year.

But he assures you that he's had conversations with venture capitalists and there's a sense that if things go right, the company might one day sell for $100 million.

Hmmm, you think. 5% -- not bad. If we sell this thing for $100 million, I will walk away with $5 million.

WRONG!

Your math failed to take into account stock dilution. That's the effect the issuance of new equity shares has on the existing shareholders.

Let's go back to our example and see how stock dilution works in action.

You take the job and get 5% of the company.

Odds are you don't get it all at once -- it's probably subject to a vesting schedule and it might only be stock options -- but that's not really relevant to our equity dilution lesson.

How much is 5% of your pre-funding company worth?

Not much. In fact, until there's a funding round you don't really know what it's worth.

A funding round is important to entrepreneurs and their employees because it's a milestone that values the underlying stock of the company.

So, let's say that a year after you've been working as the COO of the company, you and the CEO are finally able to land a funding round.

The funders says they will give you $700,000 in capital for 35% of the company.

What exactly does that mean?

It means that the total valuation of the company after they put their money in will be equal to $700,000/.35, or $2,000,000.

In VC terminology, that's the post-money valuation. The pre-money valuation is therefore $1,300,000. That's the post-money valuation minus the value of the cash that is coming into the business as part of the funding round.

So, after the funding round, the valuation is $2,000,000 and you had 5% equity in the company, so now you're equity stake is worth $100,000, right?

WRONG!

Equity dilution knocks down your percentage stake in the business.

Here's how equity dilution works in this scenario.

Let's say there were 1,000,000 issued shares prior to the funding round. In order for the new investors to get a 35% equity stake, they need to be issued new shares.

How many shares?

It's a simple algebra problem. Let x be the number of new shares that need to be issued. The equation becomes:

x / (1,000,000 + x) = .35

Solving for x implies that 538,462 new shares must be issued to the investors.

The math says that it should be 538,461.5 but there's no such thing as half a share so we round up. Believe me, investors won't round down. If there's something on the table to be taken, they will likely grab it.

So, now the total number of shares in the company is 1,538,462. What your percentage equity stake in the company?

Well, you were allocated 5% of the 1,000,000 shares so you had 50,000 equity shares before the funding round.

After the funding round, you still have 50,000 shares.

So, now, your diluted equity stake in the company is 50,000/1,538,462, or 3.25%.

How much is it worth?

The answer is simply .0325 x $2,000,000. That's your percentage equity stake times the post-money valuation. As it turns out, your stake is worth $65,000, not $100,000 as you might have thought.

If the company were to sell for $100 million now, after the first round of venture funding is in the bank, you 3.25% stake would be worth $3.25 million, not the $5 million you thought you'd get before you learned about equity dilution.

Notice that there was an easier way to figure out your post-dilution equity stake. You gave away 35% of the company in the financing round, so your 5% was knocked down by a .65 dilution factor -- that's what you got to keep, in effect. So, 5% times .065 gives you the 3.25%. It's the same answer, but it's a quick way of calculating the effect of dilution on your equity stake.

Mind you, this is just your first round of dilution. If the company has to do a second round and gives away 40% of the company to new investors, then you've got to knock your 3.25% equity stake down by a .60 dilution factor. After that second round, your ownership stake will be down to 1.95%.

Is that good or bad? It depends.

If the post-money valuation on the second financing round is $1 billion, your stake is only worth $19,500,000. Not bad!

If the post-money valuation on the second round is $2,500,000, then your equity stake is only worth $40,950. Given the salary cut you took to get in on the action for this startup, this is a pretty miserable scenario.

Adding insult to injury is the fact that your equity stake's valuation is not real -- it's just a paper value. In a startup company there's usually no liquidity unless there's an exit event of some kind -- for example, maybe the company goes public or the company is sold to an acquiring company. At that time, you finally get to know what your stock is really worth.

What's the moral of the story?

Well, for starters, you can see that somebody who doesn't understand equity dilution is going to be overly optimistic about their likely take in a startup. They may be more willing to take a lower salary than they should be, or more willing to take a lower equity stake than they should be.

Now that you understand equity dilution, you won't make that mistake. You'll properly evaluate potential outcomes and likely funding scenarios and their dilutionary effect on your stake.

Based on your equity dilution analysis, we hope you'll make smart decisions. Good luck!

Courtesy

Citibank Dilutes the existing Shareholder stakes

Abu Dhabi Investment Authority said it will invest $7.5 billion in Citigroup Inc. Once the equity units Abu Dhabi bought are converted into stock in 2010 and 2011, Abu Dhabi will hold a 4.9 percent stake in Citi. Until those units get converted, Citi will pay Abu Dhabi a yield, or essentially an interest rate, of 11 percent. This is a hefty interest rate and also the analysts estimate earnings per share going forward will be diluted by about 3 to 4 percent by the sale. A very bad move for the investors more like the scenario 3 below.


What does all this mean to an average investor named Joe?


Stock dilution refers to when a company issues additional stock, for any purpose. Some of those purposes are bad for outside shareholders, some are neutral, and believe it or not, some are actually good. We examine all three scenarios to see how they can affect us as investors.

Example.
In 2005, Phaser(a hypothetical company) had 100,000 shares of common stock outstanding, a market cap of $1 million, and $100 of net profits.An individual investor Joe, on Dec. 31, 2006, bought 10,000 shares of Phaser stock. When the company reported its earnings, Joe was elated to learn that, by virtue of his stake, he vicariously earned $10 worth of Phaser's profits. Little did he know what 2007 held in store for him.


Dilution Scenario One
In 2007, Phaser decides to engage in the worst of the three main ways that companies dilute their shares: It issues 100,000 stock options to its CEO. For the time being, Phaser has a "basic share count" of 100,000 shares actually outstanding. But because its CEO will eventually exercise his or her stock options (i.e., tell the company to issue 100,000 shares to him or her and then sell them on the open market), Phaser now has a hypothetical, or "diluted," share count of 200,000.

That's bad news for Joe. While he will still own his 10,000 shares, his ownership stake will be diluted once the company issues that extra stock. What does that mean? Well, when Phaser's share count stood at 100,000, and it earned $100, Joe was entitled to 10% (10,000/100,000) worth of those profits, or $10.

But when Phaser issues those 100,000 extra shares, Joe's shares will not equal 10% but just 5% (10,000/200,000) of all shares outstanding. If Phaser earns $100 again the next year, Joe's take from that haul is just $5. Poor Joe.

The CEO, on the other hand, gets 100,000/200,000 worth of the profits, or $50. Lucky CEO!

Thus, the primary reason Fools dislike stock dilution is that it often represents a transfer of wealth from outside shareholders -- you and me -- to insiders.


Dilution Scenario Two
Stock dilution, however, isn't always bad. But before we look at when it can be good, let's consider the iffy situation of a company that acquires another one and pays for the purchase in stock. Say Phaser wants to expand its business. Phaser's solution is to buy out a rival.Since Phaser hasn't sold anything and doesn't have any actual, er, cash, it wants to issue its own stock to target company shareholders in exchange for their shares.

Now, if the target company has a market cap of roughly $32 billion. With Phaser shares trading for $10 a stub, our intrepid company will have to issue 3.2 billion new shares to acquire its heart's desire. Doing that will dilute Joe and Phaser's other shareholders thousands of times over. In what universe could that much dilution possibly be a good deal for Phaser shareholders?


The answer requires another question: Is Phaser overpaying for its purchase? If Phaser pays a price equal to target company's intrinsic value as a business, then the dilution created by the purchase does not really hurt Joe. Yes, Joe's slice of the merged Phaser pie looks much smaller than his slice of Phaser alone does. But the new pie is much bigger. Picture this: Joe is receiving a much thinner but also much longer slice of the (Phaser+Target) pie, in return for his original wide but stubby slice of Phaser.

And there's another possibility to consider. Alone, Phaser may not be objectively "worth" the $1 million market cap that the market accords it. If Phaser's stock is overvalued, then paying for an acquisition in inflated-value stock may be a smarter move than paying in cash.


Issuing More Stock through public offering or Convertible Bonds
When Phaser gives 100,000 shares to its CEO for a nominal "exercise" price, that's bad for outside shareholders. But what if, before Phaser decides to go that route, the message-board rumor mill gets going and anoints Phaser as the next moon-rocket stock? As Phaser's stock price doubles, triples, and then jumps 10 times more, company management reconsiders, decides not to issue options, and instead sells the 100,000 shares on the open market -- at $600 a pop.

If the company's intrinsic value hasn't changed, and if only its stock price has increased, then this is great news for Joe. After the secondary offering is completed, he again owns 10,000 shares out of 200,000, or 5% -- down from his original 10%. However, Phaser itself is now worth more -- not just from the rumor-bubble pricing of its stock but also intrinsically, because the company has traded 100,000 shares for $60 million in cash. That cash now sits in the company's bank account, and Joe owns 5% of it, or $3 million.

So to sum up, whenever a company issues shares at a price higher than the shares' intrinsic value -- whether it does so to buy another company or to sell the shares and raise cash on the market -- an outside shareholder benefits, despite his or her percentage of ownership being diluted.

The above article is courtesy MF

Living in a Southern California Bubble

24 Shady Lane, Irvine, CA 92603, was purchased in January 2005 for $1,157,000. The combined first and second mortgages totalled $1,156,730 leaving a downpayment of $270.

By April 2007, they had multiple refinances on it finally with a first mortgage for $999,999, and a HELOC for $491,000. These owners pulled $333,000 in HELOC money.

Assuming they spent the entire HELOC, and assuming the negative amortization on the first mortgage has increased the loan balance, the total debt on the property exceeds $1,500,000. The asking price of $1,249,000 does not look like a rollback, but if the property actually sells at this price, the lender on the HELOC will lose over $300,000.

This is the story of a lot of households in California.

The Winner - The owners (may be...)
The Loser - The bank (lack of due diligence and loan standards)

This information is courtesy IHB

What are SIVs?

Background...
SIV (Structured Investment Vehicle) has high net worth investors like hedge funds or wealthy individuals who invest say $1 Billion in the SIV (the equity). Then the SIV issues commercial paper (CP) and medium-term notes (MTN) that pay slightly higher rates than similar duration paper. The typical SIV, according to Fitch, uses 14 times leverage, so in our example the SIV would sell CP and MTN for $14 Billion.

Now the SIV invests this $15 Billion ($1 Billion equity and $14 Billion borrowed) in longer term notes. The idea is simple: borrow short, lend long, hedge the interest rate and credit risks - and the profits flow to the investors in the SIV.

Usually the bank sets up the SIV, attracts the investors, manages the SIV for a fee - and there was always the appearance that the SIV CP was backed by the bank - perhaps allowing the CP and MTN to pay lower interest rates.


Now the problem....and how HSBC plans to solve it

Some SIVs invested in asset backed paper, backed by home mortgages. Even though the SIVs almost always invested in the highest tranches (with no losses to date), the market value of these assets has fallen recently.This means that the investors in the SIV (the equity) have taken paper losses on their $1 Billion investment.In fact many of the SIV NAVs have fallen substantially.A NAV of 71% means the $1 Billion equity in the example is now worth $710 million.


Once the value of the equity falls enough (usually 50%) there is usually a trigger event forcing the SIV to liquidate the longer term investments. A forced liquidation might not only wipe out all the remaining SIV equity, but the holders of the CP and MTN might take some losses too.


This has made potential investors in CP and MTN (not to be confused with the investors in the equity of the SIV) to refuse to buy any more CP. Since there is a duration mismatch - the investments are in longer term notes, CP is less than 9 months - the SIV is stuck with a liquidity problem when the CP comes due.


To solve this problem, a bank like HSBC could explicity guarantee the CP and MTN, and this would attract investors in CP and MTN again. But under accounting rules, this guarantee means the SIV belongs on the bank's balance sheet. The structure stays the same - the SIV equity investors still take the losses - but there is no liquidation event. If the losses exceed the equity investment ($1 Billion in our example), then the bank would start taking losses.

The balance sheet lists the assets and liabilities of the company. Moving the SIV to the balance sheet simply means adding the $15 Billion in assets (those longer term notes) to the Asset portion of the balance sheet, and moving the $15 Billion in CP, MTN and SIV equity to Liabilities. The new assets balance with the new liabilities, and there is no income or loss for the bank. Since the equity will take the losses first, any mark down in the $15 Billion in assets will be matched by a mark down in the liabilities - up to $1 Billion.

Problem for the bank?
There is an impact on the ratios of the bank - the reason the SIVs were off the balance sheet in the first place - and this limits other lending activities of the bank, contributing to the credit contraction.

The above information is Courtesy CR

Is this a confirmation to Sell?

Maybe.....


1. DJIA and DJTA must undergo a significant correction from joint new highs.(July 2007)

2. In their subsequent rally attempt following that correction, either one or both of the averages fail to rise above their precorrection highs. (Sep 2007)

3. Both averages must then drop below their respective correction lows. (Nov 2007)

For those who care, 12,846 is the number to watch..........

What is Lua?

Lua, an extension programming language (a language for extending applications). It supports procedural languages by using powerful data description facilities.

What does extension programming language mean?

There is increasing demand for customizable applications. As applications became more complex, customization with simple parameters became impossible: users now want to make configuration decisions at execution time; users also want to write macros and scripts to increase productivity. In response to these needs, there is an important trend nowadays to split complex systems in two parts: kernel and configuration.

The kernel implements the basic classes and objects of the system, and is usually written in a compiled, statically typed language, like C. The configuration part, usually written in an interpreted, flexible language, connects these classes and objects to give the final shape to the application.

Configuration languages come in several flavors, ranging from

a. simple languages for selecting preferences usually implemented as parameter lists in command lines or

b. as variable-value pairs read from configuration files (Windows .ini files, X11 resource files) or

c. as embedded languages, for extending applications with user defined functions based on primitives provided by the applications. Embedded languages can be quite powerful, being sometimes simplified variants of mainstream programming languages such as C.

Such configuration languages are also called extension languages, since they allow the extension of the basic kernel semantics with new, user defined capabilities. Lua is such a language.


What does powerful data description facilities mean?

Associative arrays are a powerful language construct for describing data used in an application.
Many algorithms are simplified to the point of triviality because the required data structures and algorithms for searching them are implicitly provided by the language.

Lua uses tabled for data description. Most typical data containers, like ordinary arrays, sets, bags, and symbol tables, can be directly implemented by tables.

Tables can also simulate records by simply using field names as indices. Lua supports this representation by providing a.name as syntactic sugar for a["name"].

Lua provides a number of interesting ways for creating a table. The simplest form is the expression {}, which returns a new empty table. A more descriptive way, which creates a table and initializes some fields, is shown below; the syntax is somewhat inspired in the BibTeX [13] database format:

      window1 = {x = 200, y = 300, foreground = "blue"}

This command creates a table, initializes its fields x, y, and foreground, and assigns it to the variable window1. Note that tables need not be homogeneous; they can simultaneously store values of all types.

A similar syntax can be used to create lists:

      colors = {"blue", "yellow", "red", "green", "black"}

This statement is equivalent to:

      colors = {}
     colors[1] = "blue";  colors[2] = "yellow"; colors[3] = "red"
     colors[4] = "green"; colors[5] = "black"

Sometimes, more powerful construction facilities are needed. Instead of trying to provide everything, Lua provides a simple constructor mechanism. Constructors are written name{...}, which is just syntactic sugar for name({...}). Thus, with a constructor, a table is created, initialized, and passed as parameter to a function. This function can do whatever initialization is needed, such as (dynamic) type checking, initialization of absent fields, and auxiliary data structures update, even in the host program. Typically, the constructor function is pre-defined, in C or in Lua, and often configuration users are not aware that the constructor is a function; they simply write something like:

      window1 = Window{ x = 200, y = 300, foreground = "blue" }

and think about ``windows'' and other high level abstractions. Thus, although Lua is dynamically typed, it provides user controlled type constructors.

Because constructors are expressions, they can be nested to describe more complex structures in a declarative style, as in the code below:

      d = dialog{
                hbox{
                     button{ label = "ok" },
                     button{ label = "cancel" }
                }
         }

What makes extension languages different?
They only work embedded in a host client, called the host program. Moreover, the host program can usually provide domain-specific extensions to customize the embedded language for its own purposes, typically by providing higher level abstractions. For this, an embedded language has both a syntax for its own programs and an application program interface (API) for communicating with hosts. Unlike simpler configuration languages, which are used to supply parameter values and sequences of actions to hosts, there is a two-way communication between embedded languages and host programs.

What are the requirements of extension languages?

• extension languages need good data description facilities, since they are frequently used as configuration languages;
• extension languages should have a clear and simple syntax, because their main users are not professional programmers;
• extension languages should be small, and have a small implementation. Otherwise, the cost of adding the library to an application may be too high;
• extension languages are not for writing large pieces of software, with hundreds of thousands lines. Therefore, mechanisms for supporting programming-in-the large, like static type checking, information hiding, and exception handling, are not essential;
• finally, extension languages should also be extensible. Unlike conventional languages, extension languages are used in a very high abstraction level, adequate for interfacing with users in quite diverse domains.

How does Lua become extensible?

In its design, the addition of many different features has been replaced by the creation of a few meta mechanisms that allow programmers to implement those features themselves. These meta mechanisms are: dynamic associative arrays, reflexive facilities, and fallbacks.

Dynamic associative arrays directly implement a multitude of data types, like ordinary arrays, records, sets, and bags. They also lever the data description power of the language, by means of constructors.

Reflexive facilities allow the creation of highly polymorphic parts. Persistence and multiple name spaces are examples of features not directly present in Lua, but that can be easily implemented in Lua itself using reflexive facilities.

Finally, although Lua has a fixed syntax, fallbacks can extend the meaning of many syntactical constructions. For instance, fallbacks can be used to implement different kinds of inheritance, a feature not present in Lua.

Where can we use Lua?
Currently, Lua is being extensively used in production for several tasks, including user configuration, general-purpose data-entry, description of user interfaces, storage of structured graphical metafiles, and generic attribute configuration for finite element meshes.

It took me 1 Hour and 10 mins to write this up on Nov 20th 2007 (9:30 am - 10:40 am). Just after bi-weekly HDK meeting.

More Information

KPP Seminars Attended

March 2006 The sun should never set on your investments - A primer on International investing

July 19th 2006 What it takes to stay ahead of the market

Oct 11th 2006 Happy New Year! – Stocks and Sectors that should shine in 2007

Nov 2006 Politics and profits - The Presidential Cycle

March 21 2007 Tough times ahead? - Prospering in a shaky market

June 21 2007 Back to the Basics - Improving your analytical skills