What is capital dilution?
The principle of dilution
Two main categories of financing can be distinguished: the so-called dilutive solutions, and on the contrary, the non-dilutive solutions.
Dilutive financing solutions are, for example, love money, business angels or venture capitalists. When it comes to bank loans or grants, the funding is non-dilutive. So how can we explain this difference and understand the principle of dilution?
The principle of capital dilution is very simple: you ask for an investment in exchange for a share of your capital, in other words you share your capital. The capital increase achieved by issuing new shares will generate this dilution. This phenomenon is therefore very common in equity fundraising.
Capital dilution vs. share transfer
Don't confuse capital dilution with the sale of shares! Indeed, in the case of a sale of shares to new shareholders, the number of shares of the founder will decrease. On the other hand, in the case of dilutionIn the case of a sale of shares to new shareholders, the number of shares owned by the founder remains the same.
In concrete terms, if a company has 100 shares, all of which are held by the founder, then he owns 100% of the share capital. On the other hand, if he decides to raise funds by issuing 20 new shares, he will only have 100 / (100+20) = 83% of the company's capital. His number of shares will remain 100.
The disadvantages of dilution
Although at first sight, financing yourself by opting for a fund raising is an interesting strategy, the principle of dilution that it causes is problematic. Indeed, by distributing shares of your capital, you reduce your decision-making power. The issue of new shares will create new voting rights for the benefit of the new associates. You will therefore have to take into account their votes in the decisions.
The dilution of capital also leads to a reduction in the amount of earnings per share (EPS). The new shares created will confer new rights to participate in the profits and the new partners will therefore receive dividends. Irreversibly, the unit amount of your dividends received before the operation will decrease.
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What are the levers of financing without dilution?
The banks
The first solution to finance yourself without dilution is obviously the bank loan. Nevertheless, the steps to obtain a loan can be quite long and the amounts can remain quite low. This alternative to the classic fund raising will require a lot of energy, because you have to convince the banks and most certainly be refused. The profitability is also a very important point for the banks, which can handicap you during your launch. Finally, some banks are quite hostile to the financing of tech companies and SaaS.
Investment funds
In some cases where the rate of return is very high, it is possible toopt for a non-diluted fundraising. Unlike bank financing, fundraising is based on specific indicators. The investment funds themselves look for these data beforehand, which will require less energy from you. On the other hand, the process of raising funds can be quite long.
Royalties
Royalties, also known as proportional royalties, are periodic fees. Their purpose is to finance the services rendered by the franchisor to the franchisee and they can take various forms: salary, balance or fees. The use of royalties avoids the principle of dilution. Their amount can be regular or variable (generally from 1 to 12% of the turnover).
The bootstrap
Bootstrapping is simply the financing of a business activity from limited equity with reinvestment of profits, i.e. no outside financing is involved. The financial risk for the founder is very high, but obviously there is no question of dilution. Bootstrapping can also slow down the potential development of a company due to lack of financing.
Participatory financing
Participatory financing, also called crowdfunding, is an exchange of funds between individuals outside of institutional financial channels. This call for funds is generally made via online platforms and is based on a description of the project. The financing can then take 4 forms:
- A gift, with no return required
- A gift waiting for a reward
- A loan with or without interest
- An equity investment
Participatory financing is therefore based on collective solidarity. It is in fact similar to mezzanine debt.
Mezzanine debt
This debt is repayable only after the total balance of a so-called senior debt. Indeed, this type of financing is subordinated to a bank debt. The term of a mezzanine debt is therefore relatively long: between 6 to 8 years compared to 4 years for participative financing for example. On the other hand, this strategy can present significant risks for the company's shareholders.
What is the best alternative to adopt?
Revenue Based Financing
Revenue Based Financing is a new financing scheme based on the company's future revenues. It allows digital companies to finance their growth in a non-dilutive way and very quickly. It is a way for companies to raise capital by promising a percentage of future revenues in exchange for the money invested. It is a good alternative to fundraising.
In Revenue Based Financing, the investor has no direct ownership in the company and does not require fixed payments. In fact, the amounts given to the investor will be proportional to the company's performance. In concrete terms, if your sales drop during a certain month, your royalties will be reduced. Conversely, if your sales increase the following month, the amounts to be given will increase in the same way.
This alternative to fundraising also has the advantage of being accessible to many types of companies. It does not require profitability criteria, exponential growth forecasts or the marketing of ultra innovative products.
Which financing solution at Karmen?
Revenue Based Financing is the type of financing we offer. The funding process is 48 hours from the time of application until the funds are received in the recipients' bank account. At Karmen, we finance digital businesses including Saas. We analyze the borrower's ability to increase revenue sufficiently to cover loan payments and operating expenses, so profitability is not a necessary criterion.
The loss of decision-making power and the decrease in the amount of earnings per share caused by dilution are avoidable. If fundraising is to be avoided because of its dilutive nature, there are other more or less efficient alternatives available to you. Among the many non-dilutive financing alternatives, revenue-based financing stands out for its transparency, speed and flexibility. It is perhaps the key to the growth of financing for digital companies.
