Equity · Dilution

How do you prevent dilution when getting equity?

Anthony Massa Software Consultant and Engineering Professional

August 9th, 2014

I'm curious if someone has a minority of ownership equity in a company, how can the minority prevent from getting diluted out?

Mike Moyer

August 9th, 2014

Short answer- they can't. Majority shareholders can change pretty much whatever they want with little regard to minority shareholders. However, you can ask for an anti-dilution clause in your contract, but such a clause should be given to all shareholders in order to be fair. This kind of thing makes equity management difficult.

Longer answer:

In many cases, dilution is perfectly fair and is a natural byproduct of a growing company. Most shareholders will be diluted as the company grows.

I am a big proponent of dynamic equity splits. The model I use, called a Grunt Fund, is a self-adjusting model that ensures that each person always has what he or she deserves to have. In this model dilution is a natural part of the process. Here is a link to a more detailed article on the topic: http://www.slicingpie.com/dilution-is-not-a-four-letter-word/


Tim Scott

August 9th, 2014

If you find a founder who will give you a "anti-dillution" condition, run as fast as possible. This is not someone you want to work with. The company will be un-fundable.

Let's say you get 30% of a company and a "no dilution" provision. You build a product. The company is still worth nothing. So you own 30% of zero, which is zero. Things go well, and the company gets some traction. Great! Now it's is worth something. How much? You are about to find out as you close a seed round.

You raise $1 million at a $3 million valuation. Now the company has two things: cash and potential.

At this point, how much of that cash is rightfully yours? $300k or $210K? In effect you have just been granted a $90,000 windfall at the expense of your co-founders and your new investor. That is no fair, and it will never happen, because no sensible investor will accept those terms.

Javier Cardona CEO at Okio

August 10th, 2014

I believe that this is a common and unsolved problem and that the practical solution is to accept equity only if you trust the founding team/majority shareholders will act responsibly.  And it is in their best interests to do so.

For instance, equity is usually a major component in the compensation package of early employees and advisors.  If they feel that stock is being given too liberally they can feel cheated, definitely something you want to avoid.

As for a contractual agreement to keep dilution within certain boundaries, I would agree with Mike: it's a pain in the neck.

Cheers,

Tim Scott

August 10th, 2014

 how does a minority equity holder protect themselves from putting in the hard work at the start and then getting kicked out once things are up and running

It's a valid concern. Finding partners you can trust and who care about their reputation is great, but it's hard to know how people will behave in the thick of battle.

Your only solid protection is to be indispensable. It's pretty rare for a startup to reach some kind of "up and running" steady state. If you ever get there, it will probably after you're significantly vested. The firm is going to absolutely need kick ass talent to always climb the next hill. I makes no rational sense to expel a rock star contributor for some new kid...just to pocket some unvested equity.

Anthony Massa Software Consultant and Engineering Professional

August 10th, 2014

Thanks for the responses.

I understand about needing dilution to invite other investors in, however, how does a minority equity holder protect themselves from putting in the hard work at the start and then getting kicked out once things are up and running?

I can understand diluting yourself if the value you are receiving is equitable from what you had when you started, but I'm wondering how best to protect yourself.

Anthony Massa Software Consultant and Engineering Professional

August 10th, 2014

Thanks for the insight, and I agree. Trust is important in any relationship, business or otherwise. 

Yes, trust is tough. And as things change that trust can disappear, and then it's too late. And the value one brings can change in someone's mind over time. 

Brett Fox Respected, Results-Oriented CEO, Entrepreneur, Author, and Coach

August 10th, 2014

Anthony,

Are you asking how an investor protects himself or an employee protects himself?  An existing investor is usually protected by terms of his existing investment.  Existing investors are usually guaranteed the ability to invest their pro-rata in subsequent rounds.

Founders usually suffer dilution as the company progresses.  Employees stock is usually refreshed, to some degree, in future rounds.  The new investors are investing in the employees, so the new investors want the employees incentivized.  Too much dilution and the existing employees will leave, and the investment is not worth as much.  

Anthony Massa Software Consultant and Engineering Professional

August 10th, 2014

Tim, yes, indispensable would be great, but everyone can be replaced...it's a matter of how big a hit the company wants to take. The heavy lifting is at the start...when there's nothing there...created from a blank screen, clean sheet of paper. It's much easier to drive the boat after it's out in the open ocean, once the product is up and running, the early lifters and rock stars seem to be overpriced and their hours spent working hard seems forgotten. At least, this is something I've seen.
 

Anthony Massa Software Consultant and Engineering Professional

August 10th, 2014

Brett, I'm asking from the employee perspective. I realize an investor is going to be protected. I'm wondering about a scenario where equity was promised, now seems to be on the back burner "until later." And if it comes up again, how can that equity be protected so early employees doing the heavy lifting of creating the products from nothing protect themselves from being replaced after everything is up and running.

I agree that employees are what is being invested in, but if those early employees aren't needed as much later, unless you're protected somehow, it's easy to get cut out. Some investors, not all, view engineers (even good ones, rock stars) as replaceable cogs to get their investment to the next stage.

I realize this comes down to trust, and maybe I'm answering my own questions, but some insight about other possibilities are always helpful.

Brett Fox Respected, Results-Oriented CEO, Entrepreneur, Author, and Coach

August 10th, 2014

Anthony,

Really good talent is so hard to find that I doubt there is an issue.  I ran a company that was 90% engineers and we wanted to treat the engineers, and the other employees, really well because its so hard to find great talent.

We rarely lost any employees even when times got tough.

The management makes the decision on hiring and firing employees, not the investors.  The investors make the decision about the CEO, not the employees.   The investors or the board of directors never asked me to give a certain engineer a certain amount of stock.  They approved every stock grant I suggested.

I hope this helps.