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