Excerpt from a Venture Capital book:
If an investor with a $100M fund has set aside $5M to invest in a particular company over its life, what proportion of the $5M should it invest in the first round, and how much should it reserve for future rounds?
Should it invest all $5M in the company in the first (or upcoming) round (when the price per unit of stock is likely at its lowest point)? Should it invest $3M to $4M now and reserve $1M to $2M for later rounds? Or maybe invest $2M now and hold a lot of capital back in reserve?
Unfortunately, the answer to this issue is, it depends. If the initial round of investment in the company is $3M (for 40%) but it is likely that two to three more rounds, each progressively larger, will be required, the investor might decide to only invest $1.5M for 20%, in the first round alongside another similarly sized investor and reserve $3.5M for future rounds. This gives the investor full protection for future rounds of investment in aggregate of $17.5M or less ($3.5M would allow the investor to play for 20%). An inability to play for 20% of all likely future rounds of investment could mean heavy dilution of the investor's ownership position if the price per share is set very low.
I'm not quite fully grasping the idea of "protection" here. Few questions:
- Why is it so important to protect yourself from future investment rounds.
- If an investor buy 20% of the company, they own 20% now. How can that become diluted if the price per share is set very low in future rounds (last sentence). I thought ownership percentage is a constant.
Thanks for any clarification.