Three Basic Rules: Dilution, Dilution, Dilution
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2005-08-02
Take a sample of 100 venture-backed companies successful enough to undertake an initial public offering. In a high percentage of the transactions, the prospectus discloses that the earliest stage investors (founders and angels) wind up with close to trivial equity percentages and thus, puny returns on their investment in the company. One would think that these investors are entitled to the lushest rewards because of the high degree of risk accompanying their early stage investments, cash and/or sweat. The problem, however, is dilution. Most early stage companies go through multiple rounds of private financing, and one or more of those rounds is often a "down round," which entails a disappointing price per share and, therefore, significant dilution to those shareholders who are not in a position to play in the later rounds.
The problem of dilution is serious because it has a dampening impact on angels and others who are thinking of financing, joining or otherwise contributing to a start up. Estimates put the relationship of angel capital to early stage investments by professional VCs at five dollars of angel capital going into promising start ups for every one dollar of VC investment. But if angels are increasingly discouraged by the threat of dilution, particularly since the meltdown, we don't have much of an industry; there is no one to start the engines. [1]
There are a variety of fixes for the dilution issue open to founders and angels.
- Make sure you enjoy pre-emptive rights, the ability to participate in any and all future rounds of financing and to protect your percentage interest. Pre-emptive rights can be, of course, lost if you don't have the money as founders and angels often do not to play in subsequent rounds.
- Try to get a negative covenant; this gives you a veto over the subsequent round and particularly the pricing of the terms.
You don't want to kill the goose of course, meaning veto a dilutive round and then once the Company fails for lack of cash; however, a veto right at least will you the opportunity to make sure the round is fairly prices; that the board casts a wide enough net so that the round is not an inside trade; meaning that the investors in control of the Company, go over in the corner and do a deal with themselves. Those rounds can be highly toxic to the existing shareholders (cram downs, as they are called). Finally, if you don't have cash try to upgrade your percentage interest with derivative securities, options and warrants (a warrant is another word for option, they are the same security, a call on the Company's stock at a fixed price but options are if the call was labeled if an employee is the beneficiary is the holder and the warrants are for everyone else). If you are the founding entrepreneur therefore, make sure you are a participant in the employee option program. Often the founder will start off with a sufficient significant percentage of the Company's equity that she doesn't feel necessary to declare herself eligible for employee options. This is a major mistake. In fact, I am likely to suggest founder client consider a piece of financial engineering I claim to have invented; the issuance of warrants in favor of the founders and angels at significant step-ups from the current valuation, which I call 'up-the-ladder warrants.' To see how the structure works, consider the following example:
Let's say the angels are investing $1,000,000 in 100,000 shares ($10 per share) at a pre-money valuation of $3 million, resulting in a post money valuation of $4 million ($1 million going into the Company). We suggest angels also obtain 100 percent warrant coverage, meaning they can acquire three warrants, totaling calls on another 100,000 shares of the Company's stock; however not to scare off subsequent venture capitalists or, more importantly, cause the VCs to require the warrants be eliminated as a price for future investments. The exercise prices of the warrants will be based on pre-money valuations which are relatively heroic win/win valuations, if you like. For the sake of argument, the exercise prices could be set at $30, $40 and $50 a share (33,333 shares in each case).
Let's use a hypothetical example to see how this regime could work. Since the angels have invested $1 million at a post-money valuation of $4 million, they therefore own 25 percent of the Company–100,000 shares out of a total of 400,000 outstanding. The three warrants, as stated, are each a call on 33,333 shares. Subsequent down rounds raise $2,000,000 and dilute the angels' share of the Company's equity from 25 percent to, say, 5 percent–their 100,000 shares now represent 5 percent of 2,000,000 shares (cost basis still $10 per share) and the down round investors own 1,900,000 shares at a cost of $1.05 per share. Assume only one down round. Finally, assume the Company climbs out of the cellar and is sold for $100 million in cash, or $50 per share.
Absent 'up-the-ladder warrants,' the proceeds to the angels would be $5 million–not a bad return (5x) on their investment but, nonetheless, arguably inconsistent with the fact that the angels took the earliest risk. The 'up-the-ladder warrants' add to the angels' ultimate outcome (and we assume cashless exercise or an SAR technique, and ignore the effect of taxes) as follows: 33,333 warrants at $20/share are in the money by $666,660 and 33,333 warrants at $10 a share are in the money by $333,330. While the number of shares to be sold rises to 2,066,666, let's say, for sake of simplicity, the buy-out price per share remains at $50, meaning the angels get another $999,999–call it $1 million. The angels' total gross returns have increased 20 percent while the VCs' returns have stayed at $95,000,000. Even if the $1,000,000 to the angels comes out of the VC's share, that's trivial slippage … a gross payback of 47.5 times their investment, vs. 47 times. If the company sells for just $30 a share, the angels get nothing and the VCs still make out.
[1] Williams, "Community Development Venture Capital: Best Practices & Case Studies," (Jan.2004)