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Crowdinvesting and dilution of shares in start-ups | weBlog

December 16, 2020
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Crowdfunding is a relatively well-known term (not only) in the start-up world today. However, this way of raising a capital from larger number of investors is not the only option for start-ups to obtain a financial support for starting a business.

So-called crowdinvesting is coming to the forefront. It is a sub-area of crowdsourcing where anonymous investors gather via internet with a purpose to achieve a specific objective. The main difference is that these objectives are financially limited. The “crowd” appears inf the form of micro-investors (natural persons and companies) with clearly defined shares in the start-up. Thanks to this new type of online investors acquisition, the start-ups may raise the capital without having to rely on a support bank or establishment of their company.However, regarding the current pandemic situation, the investors must reckon with the fact, that the start-up valuation in the next investment round may decrease compared to the original (down round). Nonetheless, they should not forget in this context, that the contracts they sign include (or should include) a clause preventing the dilution of the share. But what does it mean? In principle, it means a protection of investors if a decrease occurs and there are three possible scenarios how the down round may or may not be treated:

  • If the contract didn’t include a clause, it is a worse case for some investors. Imagine a situation where investors invest a specific amount in the start-up in the first round and gain a 10% share. In the second round, another group of investors comes and invests less in exchange for a 15% share. This leads to a situation where the post-money valuation (the valuation of a start-up after gaining an investment) decreases after the second round. The investors from the first investment round thus face a temporary loss on their investment.
  • If the contract includes a clause, it may be in a form of full ratched – simply put, in case of the down round, the investors may avoid a situation mentioned above. In order to the investors from the first round not to lose the value of their investment, they must gain such a share in the company during the second investment round that will secure them with this. This means, that after the second investment round, the value of the investors´ share in the start-up from the first round will increase from 10% to 25%. The investors from the second round remain 15% share. Thus, “only” the founder of the start-up will suffer the loss.
  • Another form of investors´ “safeguard” against dilution of their share is so-called broad-based weighted average, when in the above-mentioned cases, the founder will not be the only one diluted, but also the original investor. Another advantage is that this method considers also a value of the investment in the individual investment rounds. If its value is “negligible”, it will not affect the share of the original investor.

The mentioned provisions are important from the tax and accounting perspective. In accordance with §24 par. 1 letter b) of the Accounting Act, every accounting entity is obliged to revalue its assets and liabilities by the date of the preparation of the financial statements. According to the §27 par. 1 letter a) of the Accounting Act, the so-called available-for-sale securities and shares are also valued at the fair value. Thus, in accordance with §14 par. 7 Accounting procedures for entities accounting in the double entry bookkeeping system means a security and a share that is not a trading security, a held to maturity security, a security and shares in a subsidiary, a security and a share in a company or in a cooperative with shareholding. In practise, this is a share of less than 20% in the company in which the investor is invests. These investments are typical for crowdinvesting.

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