Pro-Rata Still Dilutes VCs

by Mark Peter Davis

In my prior post, VCs Generally Retain Pro-Rata Rights, I describe the fact that pro-rata rights do not enable VCs to do future rounds in their entirety (they are not a call option). 

One implication of the fact that Insider (existing) investors generally do not provide all of the invested capital in future rounds is that insiders can be diluted; inside investors generally own a smaller percentage of the company after subsequent investments.  While they value of their ownership should (in theory) be worth more as more capital is invested ,VCs generally see their ownership stake decline over the life of the company.

What determines whether or not the insiders are diluted is the relationship between the percentage of the company that the insiders own before the round relative to the percentage of the newly issued shares that they acquire in the round.  Simply, put existing investors need to acquire a percentage of newly issued shares equal to their pre-existing ownership percentage to maintain their ownership level in the company.  If they acquire a greater percentage of new shares, they're ownership will increase.  If they acquire a smaller percentage of new shares they're ownership will decrease.

Here are a few examples of the math in action.

No Dilution
Note the that two light green cells in the model are the same.  Venture Co is receiving a percentage of the round equal to their pre-existing ownership percentage - therefore there is no dilution.

Dilutive
In the example below, the outsider provides a larger percentage of the invested capital in the new round, resulting in dilution for the existing investors.  Note, that this is the common scenario in the development of a healthy company (when the existing investors intend to provide a minority of the portfolio company's invested capital).  Venture Co.'s ownership percentage declines from 25% to 21%.

Anti-Dilutive
In this scenario the inside investors provide the majority of the invested capital.  This scenario is most likely to take place when there is an existing investor that seeks to provide the majority of the company's invested capital, when the existing investors believe that the market is undervaluing the company or when there is not an interested outsideinvestor.  Note that Venture Co. increases its ownership through this investment.