Delusions about dilution

With some regularity, clients tell me that they want to issue employee equity that represents a fixed percentage of the company, not subject to dilution. What startup company founders should realize is that giving out equity containing an “anti-dilution” feature is an extraordinary and unusual benefit, one that should be agreed to only in exceptional circumstances.

The first thing that should be said is that founders themselves generally don’t have anti-dilution protection. If the founders own 100% of a company and then raise an equity round in which they sell 20% of the company in return for funding, they’ve been diluted by that 20%. When the Company issues incentive equity to employees, that dilutes the founders. (Or it comes out of a pool that, when originally set up, diluted the founders.)

So, if founders themselves don’t have anti-dilution protection, why would a non-founder employee get it?

I always ask the client, not-dilutable for how long? At least if you are going to offer this benefit, it should come with an expiration date, e.g., non-dilutable for the the next 6 months, or the next $X million of equity funding. It shouldn’t be forever. As a startup company goes through multiple rounds of dilutive investments (which it will, if it is lucky and successful), a small equity grant with anti-dilution protection is effectively a far larger grant.

Employees don’t generally have to be concerned that founders or executives will impose excessive dilution on their ownership, because whatever will dilute the employee is also going to dilute the founder, as a major equityholder, quite a bit more. In other words, the incentives of all of the common equityholders are aligned: to issue equity only where it is anticipated to result in value growth that more than offsets the dilution. (This is true, of course, provided that a founder has no ability to selectively issue himself or herself more equity, or below market value equity, so as to selectively dilute out employees — but that’s a different issue, and one that reasonable documents can avoid without giving broad anti-dilution protection.)

As a matter of course, the only people who regular seek and receive anti-dilution protection are institutional investors such as venture capitalists. There are all sorts of really complicated ways to effect it, with names like “full ratchet” and “weighted average” anti-dilution. If an investor comes in at a certain price and thereafter the company issues equity at a lower price (i.e., a “down round”), the anti-dilution provisions serve either to mitigate or entirely eliminate the dilution of the investor.

While such provisions are routinely given to VC’s, even there, I believe it is done to excess. In my view, VC’s are sophisticated investors, who receive preferred equity that provides substantial downside protection to begin with. The price protection they receive through anti-dilution protection is really just a way to bail them out if they’ve overpaid for their investment, and might serve as a disincentive for a company management to agree to a down round that may become necessary under certain circumstances. (That’s a post for another time.)

In the end, whether to agree to anti-dilution is like everything else in business — a negotiation. Recognize before agreeing to it, however, that it is an enormous benefit.

Now, if we could only figure out how to come up with anti-delusion protection…


Categorised as: Capital Structure, Startup Stuff