What is Equity Dilution, And How Does it Work?

INVESTMENTS

Investing in the shares of start-up and early-stage companies can be satisfying and financially rewarding. But it is also very risky.

For example:

Loss of investment

There is a significant risk that you will lose your investment. Most start-up companies fail, and it can be many years before even the most successful start-up company begins to pay dividends. You are therefore much more likely to lose your investment than you are to see a return of your capital and a profit;

Lack of liquidity

If you make an investment, you will probably not be able to sell it for many years. Although it is sometimes possible to sell shares in a start-up company to other shareholders in the same company, it is much more likely that a share sale will be impossible unless and until the company is listed on a stock exchange or bought by another company. Even the most successful of start-up companies can take years to get to the point where it can be listed or sold;

Dilution

Your investment will probably be diluted. If you invest, you will receive shares in the company. If the company needs to raise more capital at a later date, it may issue new shares. If those shares are offered to existing investors and you choose not to buy any more shares, your share of the company will decline. Your share of the company will also decline if the company only offers its new shares to new investors. The company might also want or need to offer its new shares on better terms than the terms available on its existing shares. For example, the new shares might have preferential rights to dividends or sale proceeds, a right of first refusal on further share issues, or better voting rights than the existing shares. Each of these things is likely to be to your disadvantage.

Rarity of dividends

Dividends are payments made by a business to its shareholders from the company’s profits.  Most of the companies pitching  for equity are start-ups or early stage companies, and these companies will rarely pay dividends to their investors. This means that you are unlikely to see a return on your investment until you are able to sell your shares.  Profits are typically re-invested into the business to fuel growth and build shareholder value. Businesses have no obligation to pay shareholder dividends.

The need for diversification when you invest

Diversification involves spreading your money across multiple investments to reduce risk. However, it will not lessen all types of risk.  Diversification is an essential part of investing. Investors should only invest a proportion of their available investment funds and should balance this with safer, more liquid investments

Donations and rewards

Giving money to a company can be satisfying; especially if it’s doing – or wants to do – something you think is worthwhile.
However, if you decide to give money to a company and it reaches its minimum target, it will be impossible, or almost impossible, to get it back - even if you change your mind immediately.

Loans and P2P Investments

Lending money to start-up and early-stage companies can be satisfying and financially rewarding. But it is also involves risk including Loss of investment and interest payments, Lack of liquidity, Restricted redemption rights, Unsecured investments and being bottom of the chain to be paid when a business winds up. Most start-ups fail, and it can be many months or years before a successful start-up begins to make enough money to be able repay its debts. There is a significant risk that the company you lend money to:

•   Will not be able to pay you back. If the company you lend money to cannot afford to repay you, you will lose some or all of the money you loaned to the company. You will also lose some or all of the interest you expected to receive in return for your loan;

•   Will not be able to pay you back on time. If the company you lend money to cannot afford to repay you when the repayments are due, you may have to wait – perhaps for many months or years – to recover the money you loaned to the company and the interest you expected to receive in return for your loan;

•   Will become insolvent. If the company you lend money to cannot afford to pay its debts to you or to its other creditors, the company may be wound up, dissolved or put it into receivership, liquidation or administration. If any of these things happen, you may not be able to recover the money you loaned to the company or the interest you expected to receive in return for your loan. You may also have to wait many months or years to recover any payment, and that payment may be much less that you would have been entitled to receive if the company had not become insolvent. This might happen because some of the company’s creditors (including the receiver, liquidator or administrator) might be entitled to receive their money before other creditors, and when they have been paid, the company might not have sufficient funds left to pay you.

•   Investments that are made via Peer to Peer platforms should not be considered deposits like a bank. Your capital is at risk and is not covered by the Financial Service Compensation Scheme (FSCS).

Estimated reading time: 2 min

Due to the potential for losses, the Financial Conduct Authority (FCA) considers these investments to be high risk.

What are the key risks?

1. You could lose the money you invest
   • Investments in property related shares are typically made through single purpose companies for a specific project. Investors in these shares can lose 100% of the money they invested.
   • Most bond investments are in start-up businesses. Investors in these bonds often lose 100% of the money they invested, as most start-up businesses fail.
   • Many peer-to-peer (P2P) loans are made to borrowers who can’t borrow money from traditional lenders such as banks. These borrowers have a higher risk of not paying you back.
   • Advertised rates of return aren’t guaranteed. If a borrower doesn’t pay you back as agreed, you could earn less money than expected. A higher advertised rate of return means a higher risk of losing your money.
   • Certain investments can be held in an Innovative Finance ISA (IFISA). An IFISA does not reduce the risk of the investment or protect you from losses, so you can still lose all your money. It only means that any potential gains from your investment will be tax free.
   • NextFin carries out limited checks on the businesses you are investing in, more details can be found in the Risk Statement. You should do your own research before investing.
2. You are unlikely to get your money back quickly
   • Even if the business you invest in is successful, investment projects can overrun which can extend the length of time your funds are tied up in the investment.
   • Property investment projects rarely offer to pay you back through dividends. You should not expect to get your money back this way.
   • The platform does not offer a secondary market. While another investor may be interested in buying your investment, there is no guarantee you will find a buyer at the price you are willing to sell.
3. Don’t put all your eggs in one basket
   • Putting all your money into a single business or type of investment for example, is risky. Spreading your money across different investments makes you less dependent on any one to do well. A good rule of thumb is not to invest more than 10% of your money in high-risk investments.
4. The P2P platform could fail
   • If the platform fails, it may be impossible for you to collect money on your loan. It could take years to get your money back, or you may not get it back at all. Even if the platform has plans in place to prevent this, they may not work in a disorderly failure.
5. The value of your investment can be reduced
   • If an investment project overruns (time or costs) the company may issue new shares or increase its borrowings. This could mean that the value of your investment reduces as a result of more debt to pay or more shareholders to be repaid.
   • Any new shares or additional borrowing may be payable before the existing shares or bonds which could further reduce your chances of getting a return on your investment.
6. You are unlikely to be protected if something goes wrong
   • Protection from the Financial Services Compensation Scheme (FSCS), in relation to claims against failed regulated firms, does not cover poor investments in P2P loans or poor investment performance. You may be able to claim if you received regulated advice to invest in P2P, and the adviser has since failed. Try the FSCS investment protection checker here.
   • Protection from the Financial Ombudsman Service (FOS) does not cover poor investment performance. If you have a complaint against an FCA-regulated platform, FOS may be able to consider it. Learn more about FOS protection here.

If you are interested in learning more about how to protect yourself, visit the FCA’s website here.

For further information about investment-based and loan-based crowdfunding, visit the FCA’s website here.

Further details on the risks involved in investing through NextFin can be found here.