For many entrepreneurs, dilution is a scary proposition, and it’s hard to blame them. This business that they’ve created, and poured their blood, sweat, and tears into, is being taken away from them. However, that negative view of dilution can be harmful to the entrepreneur because the scary future they are envisioning doesn’t necessarily come true after dilution.
The difference between dilution and losing majority control of the company is blurred, and one frequently effects the other when entrepreneurs are considering accepting funding.
Too often, I talk to entrepreneurs who have a great idea, fantastic business, are open to investment, but can’t pull the trigger due to their fear of dilution. The typical conversation goes something like this:
Me: So, what did you think of the offer?
CEO: We’re gonna pass.
Me: Why? They are offering a valuation of 3 times your last round only 18 months ago.
CEO: Yeah, but their offer was too dilutive.
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On the one hand, the CEO is correct, but only because any issuance of additional stock is dilutive. If a company sold $1 million worth of stock at a $100 million pre-money valuation, that would be dilutive in the technical sense. Depending on the starting point, however, that might be a great deal.
Confusion About Dilution
It is easy to confuse dilution with industry jargon – particularly the term “anti-dilution.” As the terms themselves suggest, dilution and “anti-”dilution are essentially antonyms. Anti-dilution exists to protect investors (who typically purchase preferred stock) from future stock sales of preferred stock at a lower price per share than they paid. It refers to an adjustment to the price at which preferred stock converts into common stock if a company later issues additional shares of preferred stock for a lower price per share.
As the result of such an adjustment, each outstanding share of preferred stock becomes convertible into more than one share of common stock. As a general matter, an issuance of stock that triggers an anti-dilution adjustment is indeed a bad result for founders and other common stockholders. That said, while all anti-dilution adjustments (including the issuance of stock that triggers the adjustment) are dilutive, not all dilutive issuances will trigger an anti-dilution adjustment.
Control vs. Ownership
The corporate concepts of “control” and “ownership” are often conflated. As a practical matter, these are distinct issues. CEOs of large public companies, for example, exercise enormous control over the companies they run, but almost none of them hold majority (or even significant) ownership stakes. Laws relating to corporate control and governance give tremendous power to a corporation’s board of directors. Corporate board composition need not – and usually does not – simply mirror stock ownership. A founder team holding less than 50% of their company’s stock may well hold a majority of the company’s board seats.
At the very least, board composition is a highly negotiated issue between management and outside investors. Finally, investors familiar with the wisdom that “you bet on the jockey, not the horse” understand that whatever the formal arrangements may be, founders should – and typically do – exert enormous influence over developing companies. More typically, investors seek to negotiate “negative” control rights that give them the ability to prevent a company from taking specified actions without their consent. Few early and growth stage investors seek to obtain operational control of a company in connection with their investment.
A Practical Scenario
An example might be helpful here. Consider the following scenario:
- $29 MM pre-money valuation with a $36 MM (post-money) valuation
- Founders’ ownership percentage would fall from 60% to 48%.
- A previous investor’s ownership percentage would fall from 40% to 32%.
- The new investor would own 20%.
This tells an optimistic but not unrealistic story. The above company initially raised $4 million at a $6 million pre-money valuation. It then received an additional investment of $7.2 million at just under a $30 million pre-money valuation. From the founders’ perspective, the value of their stock increased from $6 MM (60% of $10 MM) to just over $17 MM (48% of $36MM) – which is nearly a 3X increase! That should make them feel like this:
Both investment rounds were technically dilutive to the founders (although the first round far more so than the second), but the second round would not have triggered an anti-dilution adjustment for the earlier investors. A realistic board composition for this company might be 5 individuals, with 3 directors being nominated by the founders, one by the first investor group and one by the second.
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In my experience, the big hurdle lies at the 50% ownership threshold. As discussed above, holding less than a majority of your company’s stock does not mean that you cease to control your company. From a value perspective, the above example illustrates the truism that it is often better to own a smaller piece of a bigger company than a bigger piece of a smaller one. Here, the founders nearly tripled their wealth in exchange for an incremental 20% dilution. That may not always be a great deal, but it is not always a bad one either.
When thinking about dilution, please consider the following 4 items:
- Although dilution always leaves you with “less,” sometimes less really is more.
- Dilution and anti-dilution are not the same thing. All stock issuances are dilutive; far less than all result in an anti-dilutive adjustment.
- Control and ownership are very different. In particular, control is not purely a function of ownership percentage. Also, a Board of Directors is a powerful actor in the world of corporate governance.
- In fairness, not all dilution is good, either. Valuation is a key term in any negotiations between founders and investors. If the parties are too divergent on this issue, consider alternative financing structures, such as convertible notes. I wrote an article here on Silicon.nyc about SAFE and convertible notes, which you can find here.