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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:

  1. Why is it so important to protect yourself from future investment rounds.
  2. 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.

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1 Answer

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Hard to tell without more context, but this is probably referring to a right to participate, pro rata, in future financing round. The idea is that if you buy 20% of the company in a Series A, then you also have the right to buy 20% of the Series B, and so on. This provision is usually contained in an investor's rights agreement that you and the company sign when you invest.

In answer to your questions:

(1) Any round is dilutive -- in other words, when other people buy shares, your percentage of the company necessarily goes down. If, in a later round, the company sells shares for less than what you're currently paying, then your holding goes down disproportionate to the amount you have invested.

(2) Ownership percentage is NOT constant. If the company has 100 issued shares today, and you buy 20 of them, you own 20%. If the company then sells another 100 shares to somebody else, you now own 10%.

On #2, let's say that you paid $20/share, but the next person only paid $5/share. You would have put in a total of $400, the company's worth $2500, but you only get $250 if it folds. (Assuming that it hasn't spent the money.)

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