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« Taking draws vs. salary | Main | Authorized vs. Outstanding Shares »
Monday
Jan192009

Dilution issues for Founders

Many new entrepreneurs are hung up on some kind of magic number in terms of percentage of ownership.  This latest question from John reflects that sentiment.  In general, I encourage people not to think about the ownership they currently have, but in terms of whether or not the dilution is worth it with every new stock issuance.  Hiring that new person or raising that new capital is either worth the dilution, or it isn't, regardless (again, in general) of where that leaves the cap table.

John writes:

I've heard of founder stock with non dilution clauses. For example stock will not be diluted until x valuation is reached.

For example, as a founder i don't want to see my percentage of ownership fall below say 40% until we've reached a post money valuation of 10,000,000.

in other words the stock is out of the dilution pool until that point.

Can you elaborate or offer other strategy.

While you can certainly structure ownership in a seemingly endless number of ways, the strategy you describe above seems fairly pointless.  Assuming you own 100% from day 1, you are going to dilute yourself with every employee you hire, every investor you bring on, and every vendor you pay in stock instead of cash. 

Let's say that you do all of this, and over time you end up where you are right at that 40% threshold without hitting your desired $10M valuation.  The next person you hire would normally dilute you and everyone else that's an owner in the company.  However, if you have an anti-dilution clause, then you would not be diluted, and instead everyone else in the company would be diluted even more (approximately 40% more in this case).

It's not illegal to do this, if it's how the agreements are constructed, but it strikes me as patently unfair.  To simplify, let's say you own 40%, I, as your first employee, own 20%, and a handful of investors own the remaining 40%.  Now you want to bring on a world class vice-president of widget construction, and give that person 10%.

Normally, you would issue new shares to this person giving them 10% ownership.  Everyone else, who still holds the same number of shares they did before this person was hired, is diluted proportional to their existing ownership. 

Under your scenario, the investors and I (as your employee) would take all the dilution, as you are given extra shares to maintain your 40% ownership.  I certainly don't know of any investors that would tolerate that kind of clause, and as an employee, I would feel like you really hosed me.

More commonly, you might set aside a stock option pool from which new option grants are made.  So, lets say you own 40%, the investors own 40%, and you have a completely unused option pool, of the remaining 20%.  If you hire me for 10% of the company (in options), then I get those options, you still have 10% free in the options pool, and no one suffered dilution - at least on paper.  This would continue until that option pool was completely used up.

However, keep in mind that this is a really more of an accounting trick than it is reality.  If the company were acquired at a time when the option pool had unused space in it, those unused options would be removed from the ownership calculation, probably to the benefit of the actual shareholders (not option holders).  So, lets say you and the investor each have 40%, the pool has 20% but is unused, and the company is acquired.

What happens?  Perhaps obviously, you and the investors will split the proceeds 50/50.  In reality, you have 50% fo the company, it's just that everyone has "agreed" to set aside extra stock for new employees.  In this way the pool gives management the flexibility of issuing new shares without needing to get approval from your investors for every single new hire. 

This, however, is just a technicality.  A sophisticated investor is probably going to require some kind of approval for most hires anyway when those hires would receive a big piece of the option pool, so you really haven't saved yourself much headache.  It is my opinion that investors will often use an option pool to disguise how much of the company they actually bought from an unknowledgeable entrepreneur.  As is the case in this example, you actually sold 50% of your company, even though the cap table will read 40% you, 40% investors, 20% option pool.  Sure, the option pool is there to fuel growth, but don't think for a minute that the investors will let you dole out big pieces without approval, or suddenly give yourself most of those options just prior to an acquisition. 

All that said, I think you are letting yourself get hung up on a non issue.  Every time you issue shares, you are diluting anyone who already owns shares.  It is fair that everyone who owns shares would be, in general, diluted proportional to their current ownership.

Yes, there are exceptions.  What if you give up board control, or management control?  Certainly then, having some consideration that you don't get wiped out by the new people in control is justified.  That, however, will be relative to the circumstances under which you give up that control, and will be negotiated then in most cases.

Hope this helps.  Again, follow-up questions are always welcome.

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Reader Comments (1)

I have two partners in an enterprise I founded to manufacture and sell a patented biofeedback sports training device. In consideration for a royalty agreement and controlling equity in a C corporation we founded, both my co-inventor partner and I have assigned the patent over to this entity (the parent).

A tremendous amount of cash and sweat equity has been invested by me and my co-inventor over the past 10 years. The 3rd partner developed the protocol for using the device as a golf training aid but has only invested sweat equity. For this he will get 25% equity in a wholly owned golf subsidiary of the parent company plus receive a royalty for the protocol he develops in the subsidiary.

Our invention has many applications throughout the sports world as well as medical applications including health and therapy. Because of its many uses in so many diverse (some unrelated) fields, we have decided to set up several LLC subsidiary companies to function as distribution/licensing entities. Each subsidiary would be granted exclusive rights to license or sell the IP, all content/software developed by them (i.e., mobile app videos) and product purchased from the parent for each application/market they will target. Each subsidiary purchases product (hardware only) at the most favorable volume discounted price regardless of quantities purchased. Royalties will flow back to me and my co-inventor from sales by the subsidiaries.

Here's my question: Each subsidiary will be a profit center for their investors' ROI. How can the parent still retain 100% ownership in each subsidiary under this structure? Without dilution of the equity in the parent?

July 9, 2014 | Unregistered CommenterDavid

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