Founders’ Protections Against Dilution

I’ve had founders come to me worried about dilution of their equity stake cause by bringing on investors — although they’re more worried about keeping control than simply a bigger chunk of the company, they ask me how it’s possible to keep their same equity stake. The fact is, founders are going to get diluted. Although there are several anti-dilution provisions that permit any shareholder to keep their equity share (or something close to it), when founders grant those sorts of provisions to themselves it sends a red flag to investors, who expect founders to take the first hit when it comes to dilution, and may insist on having anti-dilution provisions themselves — if everyone is protected by anti-dilution, then there’s no one to dilute! Besides it’s better to own 20% of a company worth millions rather than 100% of a company worth nothing. Of course, there are some protections against dilution, particularly if founders are simply interested in keeping control over their company. The first step is to avoid “full ratchets” — these allow investors to receive additional stock in the event the company does a further funding round at a lower valuation, as if the earlier investors had bought in at the now lower price. But if a founder is simply concerned with not having their control diluted, they can make changes to the governance structures of the company, such as classes of stock, the board of directors, or voting power. The board of directors can be structured such that certain seats are elected by certain shareholders — professional and institutional investors may insist that they be given board seats that only they can elect people to — but founders can also create board seats that only they can elect themselves to. Founders can also give their class of stock super-voting power, such as having 10 votes for every share they own. In that example, a founder who owns 200,000 of 1 million outstanding shares only owns 20% of the equity, but has 2 million votes to the remaining 800,000 votes. Of course, founders must be careful not to go too crazy with structures such as these. Investors may be leery investing in a company in which a founder retains complete control, and thus could simply ignore an investor’s recommendations or concerns. If an investor is going to give you hundreds of thousands or millions of their dollars, they will likely want some say in how that money is spent. Therefore, while protecting your ability to direct the company, you will also want to provide for your investors to have a voice in company operations.

Leave a Reply

Your email address will not be published. Required fields are marked *