Incorporating Share Dilutions In Valuations

Incorporating Share Dilutions In Valuations

One challenge investors often confront when valuing young promising startups is capturing the effect of share dilution. For instance, for startups to scale, they need to reinvest. Thus, these startups have negative cash flows during the initial years. If the startup needs to sustain itself, it needs capital, and investors provide money by issuing additional equity. As startups receive additional capital, there will be equity dilution. Most startups look to raise capital from existing investors, and if they dont accept it, they search for new investors. These startups raise money by issuing additional equity, thus increasing the overall share count. This process increases share dilution. Many analysts incorporate this dilution effect in their DCF valuation by adding outstanding shares, thus reducing the startup’s value/share.

In my view, as these future equity issuances get used to cover the negative cash flows, we are incorporating the dilution effect by taking the present value of these cash flows into the consolidated value. In other words, these negative cash flows in the initial years reduce the overall valuation and compensate for any additional share count.

Thus, there is no need to estimate and adjust for future share issuances in the share count in a DCF valuation because it is already in the value.