What Is Equity Dilution In A Regulation D Syndication Or Fund Offering?
When one of my clients calls me
and they want to make changes to
their offering something that's
already taken place, and there's
already been investors in there,
they've already contributed
money. There's one thing that's
going on in my head, it's front
and center that I'm always
analyzing. It's not necessarily
something I'm always talking
with my clients about if it's
not necessary, but it's always
the first thing I'm checking in
my head to see if there's an
issue. Let's talk about what
that is.
So what is that one thing? That
one thing is dilution. dilution
is a bad bad word when it comes
to private equity, or
syndications or private equity
funds, or whatever it is that
we're doing. In the investment
world dilution is deadly. And
dilution, not only is bad for
investors, but it's also very
bad for you as a fund manager or
a syndicator. It's bad because
it's bad for investors, because
investors start to lose faith
almost instantly, as soon as
they see it happening. Now, it
may be subtle sometimes. And it
may not really be aware that
it's even happening at all. But
ultimately, somebody's going to
pick up that there's been a
dilution, and then there's going
to be phone calls happening. And
they're not going to be happy
phone calls when you don't have
the answer there. So that's why
the dilution problem is always
front for and foremost in my
mind, within the time we're
changing anything, because I
don't want to have to get the
phone call of why didn't she
tell me that that happened. And
obviously, I want my investment
my syndicators to be extremely
successful, and preventing
dilution, or if it dilution is
going to be happening, making
sure everybody knows this is why
it's happening. This is the
whole point of it. It's an OK
thing because of this, because
that happens sometimes, too. So
let's talk about exactly what it
is. And how it happens. Here is
a simple whiteboard of that
describes what happens. So let's
say all of your investors are
here. Right, you've got a whole
slew of people. And they've all
put into your investment to buy,
let's use a piece of property as
an example. So they've bought
into this property. And I'm
going to tell you that the way
this comes about more often than
not, so if they bought into this
property, now the years go by,
it's year one, year two, year
three, I had suddenly, in year
four, there is a big, big
problem. There is this property
that you still have. And let's
say that there is for just
there's 100 units, right? That
are that are being divided. So
100% of the property is being
divided amongst the investors,
there is a big problem. This
property is under has some
regulatory issues. And now
suddenly, it needs $2 million
put into it. You have a choice,
you can do a capital call and
call up those previous investors
and say, Hey, investors, I need
$2 million, or we're in big
trouble. Or, hey, you need $2
million. It worked really well
braising that money before.
Let's get a few people together
here actually, let's use a
different color. Let's get a few
people here
to give us $2 million. And when
it comes to that percentage,
we're going to make it so that
these people now have 20%. And
the blue people now have 80%. So
you see how we went from 100%
down to 80%. That's why we use
the word dilution because it's
suddenly diluted their value of
their property is now gone.
That's the problem and that's
how it comes about. Now there
are times where dilution is a
good thing. Maybe it's Something
like, hey, look, we actually
need this $2 million. Because
we're going to realize a gain of
400%. If we raise that
additional $2 million, if we
don't do it, it's going to be
worth 100% of what its original
value is, that's a good reason
to say, hey, look, we're going
to dilute. But the reason we're
diluting here is by bringing in
$2 million, and new investors
can bring it in to. So it also
can be from you as part of a
capital call, you could also
bring in that value. So if if my
current investors only bring 1
million, I can bring in 1
million from the outside world.
But the reason is, because we're
going to have this huge gain,
everybody's happy. If it's
communicated that way. And
that's the truth, then you're
not going to have the same angry
phone calls. But this is how
dilution happens. So how do we
work around it? Well, you can
work around it a few ways. You
can say to your your people,
hey, look, we've got this thing
we could do a capital call. The
most common way to deal with
this exact situation that we
have here is to say, okay,
they're going to take $2
million, we're gonna we need
that $2 million to be raised.
But we're gonna do it as debt.
We can't do it any other way.
And so we're going to raise it
as just pure debt. And then
we're going to pay that back at
some rate. That way, then 100%
of the equity is still owned by
the blue people. There's no
dilution, and we go our way.
That's dilution and how it
happens. So you can see why
whenever there's a change,
that's the immediate thing that
I'm thinking about, is their
dilution air. How do I prevent
it? How do I work around it if
there is a dilution. So let's go
through the key takeaways from
this topic of dilution. Number
one, equity dilution because
that's what we're really talking
about is equity diluting it
happens when the company or the
syndication or whatever issues
new units, reducing the
ownership stake of the existing
investors and value of their
units. This process is all is
only used for raising that
additional capital. But if it's
not done right or explained to
them, right, your investors are
gonna be furious and calling you
on the phone. Number two, the
stake value can decrease due to
a lot of different factors,
including performance, financial
health market conditions,
understanding how those our
external factors as him impacts
it, it's important in order to
manage the investment
effectively, and make sure that
those dilutions aren't
happening. Number three, the
share dilution can impact your
existing shareholders by
reducing their overall reward so
that the distributions that
they're entitled to their
percentage of equity, therefore,
it's crucial that you understand
exactly how they're structured,
what that percentage of
ownership is, and be prepared,
if there is going to be a change
in that percentage of ownership
that you get in front of it and
explain it well. Lastly,
navigating this share dilution
issue requires an understanding
not only of the impact of the
equity, just the dilution, but
also balancing the desire to
basically have your assets grow
in a way that gives a positive
thing like in that example,
where the with the 400% and
making sure that it's
communicated in a very clear way
to your investors, and listen to
what their opinions are.
Because, boy, if there is a
perceived dilution problem,
emphasis on problem, you've got
a big problem. And that's just
the kind of thing you don't want
at the end of the day. My name
is Tilden Moschetti. I am a
syndication attorney for the
Moschetti Syndication Law Group.
If we can help you with your
Regulation D offering under Rule
506b and 506c, we'd be happy to
talk with you and talk about
what you're working on.
Ultimately, we want all of our
syndicators and fund managers to
be as successful as possible to
help them grow from where
they're at today to whatever it
is, whether it's a billion
dollar hedge fund, like we've
done for other clients, or
whether it's just you want to do
multiple deals for friends and
family. We'd be happy to be part
of your journey and can
definitely show you the way give
us a call or look at our website
and sign up for a consultation.
And let's see if I can help you