Dilution

Dilution -How do you protect early stage friends and family investors against later stage dilution?

Jennifer Chapin Strategic Business Consultant & Entrepreneur

September 29th, 2015

Dilution -How do you protect early stage friends and family investors against later stage dilution? 

Benjamin Olding Co-founder, Board Member at Jana

September 30th, 2015

[Edit: fixed link]

I had to look up what a SAFE was; had not seen it before. Here's a slightly out of date article from the WSJ on it.

Anyway, Lane & Brian are both right: you can't protect any class of investors more than any others, BUT professional investors will include plenty of ways to protect themselves, the chief one being pro rata rights (right to buy more shares at later rounds). Since your friends & family are unlikely to be sophisticated enough to negotiate these in a way that won't scare off professional investors (who are allergic to "weird" terms), the right way to have them invest is through a convertible note (or apparently a SAFE, though that's new to me - maybe it's becoming common?), which will land them the same terms as your first priced round.

If I read between the lines of your post though, the real thing you need to work on is explaining how startup equity works to people who have never been involved in a startup before. This is a very worthwhile skill as you'll need it more often than you might expect with employees - even executive hires. Being sophisticated in business does not necessarily translate to being experienced with finance. It's OK to add people to your team who are clueless about equity & will try to negotiate weird clauses for themselves (it happens). You just need to find a low-stress way to handle these situations.

The two things you want to work on explaining in a friendly, feel-good way are:

1) How friends and family can get the same anti-dilution protections professional investors use.

2) How everyone can win with a smaller piece of a bigger pie (i.e. dilution is a good thing, not a bad thing). Yes, this is obvious & kind of concerning the nth time you explain it - the key is to find a way to explain it that is natural for you personally and treats the person you are speaking to as an equal rather than someone who is uninformed. It smooths out a lot of problems - but it only works if people don't feel talked down to.

Most people who you work with aren't greedy - they just want to be assured that they aren't going to feel foolish if the company is successful and that you personally "have their back." Communicating these two ideas in a friendly way is much more effective than creative financial terms (which you will always eventually come to regret doing no matter how clever it seems at the time).

When it comes to finance, keep it simple! Spend more time on relationships and less on unique terms (this rule goes for all stakeholders, including professional investors).

Lane Campbell Lifelong Entrepreneur

September 30th, 2015

A couple of things you can do.  The first is offer a right of first refusal to the early investors that they won't be diluted without first being offered the right to buy more shares at the new valuation.  I'm fairly certain you can also issue a SAFE to the early investors and have it convert to equity at the later valuation but to be sure you would need to consult with an attorney.  I recommend http://www.sentientlaw.com for this kind of work, they are experts at startup law and really great to talk with.

Robert Tolmach Entrepreneur and Social Entrepreneur

September 30th, 2015

Benjamin wrote, 

"The right way to have them invest is through a convertible note (or apparently a SAFE, though that's new to me - maybe it's becoming common?), which will land them the same terms as your first priced round."

Totally agreed about a convertible note (you will incur far less in legal costs with it), but not with his phrase, "the same terms as your first priced round."  Convertible note holders will expect a discount (typically about 20%) off of the value of the first priced round, and smart investors will want a cap, as well. There are lots of great posts about the topic on quora, among other places. 

As to your question about dilution. You might also point out to them that the convertible note structure spares them from dilution upon the first priced round. If other angel investors also invest via convertible notes, the Series A would be the first priced round, so your family would be dilution-free until then.

 

Benjamin Olding Co-founder, Board Member at Jana

September 30th, 2015

Yeah, I meant same anti-dilution protection terms - you're right the valuation (price per share) may be cheaper through the discount and/or cap for the note holders.

However, and this is often a very unpleasant experience for people who don't do much with startups, every round is an opportunity to renegotiate previous terms.  This is a revelation to people who have never seen it happen before.  So, I'd be cautious selling unsophisticated family & friends on the idea they are definitely going to get a 20% discount over your first priced round professional investor round.  

The full discount could happen - maybe even likely will happen - but I have seen investors come in stating they aren't going to get worse terms (including valuation) than non-professional investors in a previous round (or worse than 10% or something along those lines).  Real angel investors - who presumably add value beyond cash - are unlikely for investors to quibble too much with, but friends & family can be viewed as just some early dumb money (no offense to anyone's friends or family).

A discount of up to 20% is fine to have on the note with friends & family, but I'd raise their awareness it might end up less than whatever you choose as a result of negotiations with the first priced round - but assure them it will not be worse than the first priced round.

You can even tell them you'll fight for their discount if that's really important to you; you never "have" to accept a priced round, but when you need cash, this one is really hard to fight for in the grand scheme of things - and you don't want people to feel like you pulled the rug out from under them if this situation does come up.  With investors who are looking to *you* for help with figuring out terms, trust - not terms - is the thing you want to be focused on.  Treat this group very gently even though you're using the same financial instruments as you would with an angel.  Go out of your way to discuss worse-case scenarios they may be clueless about, even while assuring them you're there to work for them.

Brian McConnell

September 29th, 2015

Right off the bat you are signalling that you want to have two teams. Friends and family. And everybody else. When you raise money everybody gets diluted including founders. If i were an investor i would head for the door as soon as i heard this. Sent from my mobile phone. Please excuse any typos or discombobulations.

Bob Smith Consulting to Boards, CEO's and Key Management Teams, Strategic Investor and Fast Growth Companies

September 30th, 2015

I think all these answers have good merit.  My own take on this is that you want to protect your early supporters and thank them by seeing to it that they get the best return.

It might be useful to talk to a few people who have had successful exits and find out how things worked out for the early F&F investors.  Also, taking the time to set, manage and reset expectations will be very helpful.

There are tools and strategies (as mentioned above), and the real key is to understand the best ways they can get the best returns through time.  The more educated they are about how the dance works, the better off they are at making good decisions. 

F&F is money that comes (very often) from people who believe in you, hope for the best and are considered as you make decisions going forward,