Why is dilution a bad word? It is the lifeblood of biotech so this seems backward. Dilution is only bad when someone else pays less per share than you did. You have to mark your position to market writing off or up the difference in value (number of shares purchased times the different in stock price of what you paid and what the new investors paid). You’ve also taken on more risk than the new investor (unless there was a failure and the company is now earlier stage) and were not compensated for it. VCs complain mightily that they don’t “get paid” to go early and thus why take the extra risk if you don’t get a step-up? I know of a private biotech company which did a flat round and 6 months later got taken out for a 4x return. All investors got a 4x only one had to wait 6 months while the others waited several years. What is the alternative?
If a company faces a flat or down round, often insiders will pony up the capital to keep the company humming until its next “value inflection point”. You can only do this so many times, however, with most VCs not willing to commit more than $20m per company ($500m fund / 20-25 companies = $20-25m per company. It will then become harder for the company to raise the next round, if needed, since the insiders will be tapped out and thus the effective raise will be larger since a smaller percentage will come from insiders.
So what does this all mean? Clearly VCs need to realize that dilution isn’t necessarily bad if you raise money at an up round. A down round might also not be so bad since it will set the company up for eventual success and you can then invest more money at a lower valuation (NOTE: A small round at a down valuation is not nearly as dilutive as a large round at a down valuation. The larger the round and the lower the stock price the worse the dilution). The fact that another VCs got in later with less risk and a lower price might hurt your ego but at the end of the day, your ego doesn’t determine your carried interest, your returns do. I’ll discuss the ideal size of VC funds in a future post.