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/


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 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.

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.

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.

Rob G

August 11th, 2014

"they" (management and/or a majority shareholder or group of shareholders that total a majority) may be able to terminate your employment but they cannot terminate your stock (vested stock/options).  If your minority ownership stake is in the form of stock (not unvested options or restricted stock subject to clawback) then your stock is yours.  As the company uses it's stock (to raise money or attract more talent) you will get diluted unless management decides to grant you more stock/options (vesting schedule aside).  Since every stock owner (not including investors with pro rata clause in their agreement) get diluted its hard for management to agree to not dilute you when they are getting diluted themselves and as Tim mentioned you won't need to worry about it if there's an anti-dilution provision in an employee or founder agreement because the company will never get funded.  Put yourself in the shoes of the founders and investors and the conversation looks very different.  You are essentially in the same position as any employee in any company (assuming at-will employment) - your future with the company depends on your performance (and politics, etc.).  If you are indispensable then management will do whatever it takes to keep you around even through tough times including granting additional stock/options.   Otherwise, not so much.   Everyone (founders, employees, advisors, etc.) will get diluted with each round. As Brett mentioned, investors can avoid dilution by continuing to invest their pro rata share in future rounds and they will be required to keep writing fat checks, but they are the exception not the rule.  If you are just joining the company then pay attention to vesting schedules (for options) and clawback/repurchase provisions (for restricted stock grants).  Otherwise dilution is a very common part of the process.  Asking for contact considerations that would prevent dilution would raise a big red flag with management, board and investors. 

Anthony Massa Software Consultant and Engineering Professional

August 11th, 2014

Thanks for the response. I understand the need to be indispensable but have been in that situation before and sometimes it doesn't come down to that, but better to be out of there in that case. 

I understand about the need to get diluted, eventually, as long as the value of what you end up with after is comparable. I wanted to see about protecting oneself after owners and investors take their share that a minority owner doesn't put in the time and effort to build something only to be cut out after it's built. 

A big red flag I've seen is when employees are told to wait until we see what the company is worth, then we'll see about compensation. 

Definitely better to be one of the original equity owners in that case but that's not this situation. All seems to boil down to trust. 

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,

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.  

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

August 10th, 2014

Anthony,

I am sorry to hear this.

It seems your issue is likely management and not the investors.  I would talk with some of the people that left if you have an ability to do so.  You might learn something.

I hope it works out for you,

Brett