When one of my clients calls me and they want to make changes to their offering – something that’s already taken place, and there are already investors who have contributed money – there’s one thing that’s front and center in my mind. 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, syndications, private equity funds, or whatever it is that we’re doing in the investment world. Dilution is deadly. It’s not only bad for investors, but it’s also very bad for you as a fund manager or a syndicator.

It’s bad for investors because they start to lose faith almost instantly as soon as they see it happening. Now, it may be subtle sometimes, and they may not be aware that it’s happening at all. But ultimately, somebody’s going to pick up that there’s been a dilution, and then there are going to be phone calls. And they’re not going to be happy phone calls when you don’t have the answer there.

That’s why the dilution problem is always foremost in my mind when we’re changing anything. I don’t want to get the phone call asking, “Why didn’t you tell me that happened?” Obviously, I want my syndicators to be extremely successful, and preventing dilution – or if dilution is going to happen, making sure everybody knows why it’s happening – is crucial. Sometimes it’s an OK thing because of certain circumstances. So let’s talk about exactly what it is and how it happens.

Here’s a simple whiteboard that describes what happens. Let’s say all of your investors are here. You’ve got a whole slew of people, and they’ve all put money into your investment to buy, let’s use a piece of property as an example. The way this comes about more often than not is like this: They’ve bought into this property, and years go by – year one, year two, year three. Then suddenly, in year four, there’s a big problem.

Let’s say there are 100 units in the property. So 100% of the property is being divided amongst the investors. Now there’s a big problem: this property has some regulatory issues, and suddenly it needs $2 million put into it. You have a choice: you can do a capital call and contact those previous investors saying, “Hey, investors, I need $2 million, or we’re in big trouble.” Or you can say, “Hey, we need $2 million. It worked really well raising that money before. Let’s get a few people together to give us $2 million.”

When it comes to the percentage, we’re going to make it so that these new people now have 20%, and the original investors now have 80%. So you see how we went from 100% down to 80%? That’s why we use the word dilution because their value of the property has suddenly been diluted. 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 too.”

It can also be from you as part of a capital call; you could also bring in that value. So if my current investors only bring $1 million, I can bring in $1 million from the outside world. But the reason is that we’re going to have this huge gain, and 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.

So how do we work around it? Well, you can work around it a few ways. You can say to 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 is to say, “Okay, we need that $2 million to be raised. But we’re going to do it as debt. We can’t do it any other way, 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, 100% of the equity is still owned by the original investors. 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 there dilution here? How do I prevent it? How do I work around it if there is dilution?

Let’s go through the key takeaways from this topic of dilution:

  1. Equity dilution happens when the company or the syndication issues new units, reducing the ownership stake of the existing investors and the value of their units. This process is only used for raising additional capital. But if it’s not done right or explained correctly, your investors are going to be furious and calling you on the phone.

  2. The stake value can decrease due to many different factors, including performance, financial health, and market conditions. Understanding how these external factors impact it is important in order to manage the investment effectively and make sure that dilutions aren’t happening.

  3. Share dilution can impact your existing shareholders by reducing their overall rewards, such as the distributions they’re entitled to and 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’s going to be a change in that percentage of ownership. Get in front of it and explain it well.

  4. Navigating this share dilution issue requires an understanding not only of the impact on the equity but also balancing the desire to have your assets grow in a way that gives a positive outcome (like in the example with the 400% gain). Make sure it’s communicated in a very clear way to your investors and listen to their opinions. Because 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 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 you just 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.