Company leaders know how difficult it can be to convince investors to risk their capital on the mere hope that a fledgling business will actually manage to take flight, thereby resulting in a significant return on those initial investments. Countless hours are spent crafting and honing pitches to persuade investors that the likelihood of this occurring is probable and therefore a worthwhile use of cash.
Of course, sagacious investors tend to demand quite a bit in return in the event that the lofty assertions set forth do not quite come to fruition. An example of the bargaining tactics investors employ is the addition of an anti-dilution provision. Although this is a fairly common condition, startup founders must tread with caution when confronted with a demand for its inclusion in any funding agreements.
Dilution in a Nutshell
Dilution can affect both an investor’s ownership percentage in a company and the value of its shares of stock. In general, this reduction occurs when the company issues a new round of shares, and thus the original shareholders own a smaller portion. To give a very simple example, if an investor owns 10 shares out of an initial 100 shares issued, and thus 10% of the company, and then the company issues another 100 shares, the investor then has 10 out of 200 shares or just 5% ownership.
In some cases, however, this dilution results from a down round in which the shares drop in price as compared to the price paid by the original investors, thereby diluting the value of those initial investments. And, this occurs irrespective of whether additional shares are even issued.
Obviously, an anti-dilution provision is intended to protect investors from dilution as it was just described. There are different ways to structure an anti-dilution provision, as it may apply to all issued shares or only some portion of them. In addition, the value of the new shares may be calculated based on full ratchet, essentially the initial share price in relation to the new share price. On the other hand, the effect of the provision can be softened so that it takes into account both the old and new price, as well as the number of new shares issued, usually referred to as a weighted average.
Regardless of which method is used, the overall outcome is that the new issuance does not negatively affect the initial investors’ piece of the pot, which of course it normally would have done without such a provision. Unfortunately, the same may not be true for the founders and employees, as this provision tends to be specific to external investors’ shares. This clearly serves as a major incentive for investors who are hesitant to commit any money to the venture.
Although the inclusion of an anti-dilution provision bodes well for investors, these provisions are usually used to the detriment of the founders and any employees who are offered stock options. After all, one of the only ways to protect some shares is by hurting the other ones. Again, there are different ways to structure this sort of arrangement, but regardless of how it shakes out, those who do not have the protection of the provision are left with fewer and/or less valuable shares.
Now, this does not mean that this sort of provision should be avoided at all costs, but if there are other effective ways to incentivize investors, then they should certainly be explored first.