How is it that Venture Capital (VC) firms receive distributions ten times greater than entrepreneurs when a company goes public? For many this seems illogical and outrageous; others might find it fair, as the VC “ventured” to take the risk of investing millions in the first place. Whatever your take may be, stock dilution is almost inevitable for founders – very few entrepreneurs own 100% of the company when it goes public. What’s important is to pay attention to the term sheets and understand how future financing rounds can affect your stake in the company.
When a VC firm wants to invest in your company they send you a term sheet. This is a non-binding agreement that sets the terms of the investment. Since the VC has its own investors (Limited Partners) to answer to, it is expected for them to provide provisions in the term sheet which protect their investment. While there are various kinds of provisions that can be added to a term sheet, I will discuss two types concerning dilution: anti-dilution agreements and liquidation preferences.
Dilution protection is any provision that protects a shareholder from a decrease in their ownership position, as far as their percentage claim is concerned. This is a concern for VCs because an early-stage company is likely to require multiple rounds of financing which will dilute existing shareholders’ claims, especially in a “down round” when new investors receive shares at a lower price per share.
An anti-dilution provision that is commonplace is Weighted Average Anti-Dilution. This provision allows existing shareholders to convert preferred shares to common shares at an adjustable rate (see this link for more detail), reducing the dilutive effect of future financing. Be aware that the more the VC’s shares are protected the more the founder’s common shares will be diluted, since the adjustable rate allows the preferred shares to convert into a higher number of common shares.
Another such provision is Full Ratchet Anti-Dilution. Essentially, this allows previous rounds to be re-priced in future rounds. For example, if a VC firm invests $1 million at a share price of $2, then they will have 500k shares. However, let’s say the firm performs poorly later on and a subsequent round is financed at a share price of $1. In such case, the conversion price of the 500k shares would be re-priced at $1 per share, which would then buy them 1 million shares and reduce the dilution effect. In fact, because this guarantees the lowest possible conversion price, this is more preferable to VCs than Weighted Average and more dilutive for the founder’s common shares.
There are more anti-dilution provisions than the two I’ve mentioned here, but the main takeaway is that such provisions may actually be necessary in order to secure capital from the VC, depending on their threshold for risk. When taken to the extreme, such as an absolute anti-dilution agreement where the ownership percentage is guaranteed, it may also prevent your ability to raise future rounds of financing. Just be aware that the more preferred stock is protected from dilution the more common stock dilutes, and the added value of securing additional capital should exceed the dilution.
The liquidation preference has to do with two things: preference and participation. Preference simply determines who gets paid first in a liquidity event, such as an IPO or acquisition. Typically, investors have a 1x liquidation preference, meaning they receive 1x the amount of their initial investment before proceeds go to common shareholders. Participation, on the other hand, has to do with preferred shareholders receiving the remaining proceeds after their 1x liquidation preference on an as-converted basis, according to the rate at which their preferred stock converts to common. Participation can also be capped by a multiple of the initial investment.
For example, let’s say that a VC firm invests $3 million to buy 50% of the company and later on there is a liquidity event with $10 million of proceeds.
Case 1: If the VC has a non-participating 1x liquidation preference, then it receives 50% of the proceeds before common shareholders. Total Distributions = $5 million
Case 2: If the VC has a participating 1x liquidation preference, then the firm receives its initial investment of $3 million and also receives 50% of the remaining proceeds. Total Distributions = $6.5 million
Case 3: If the VC has a participating 1x liquidation preference with a 2x cap, then it doesn’t participate because the $3 million and 50% of remaining proceeds exceed the 2x cap of $6 million. Instead, the VC firm will only receive 50% of the proceeds, as in Case 1. Total Distributions = $5 million
As you can see, a liquidation preference for investors with participating shares can really juice the return. Although this does not dilute the percentage claim for common shareholders, it dilutes the proceeds available to them in a liquidity event. Moreover, if proceeds do not exceed the initial investment of participating preferred shareholders, there will be no proceeds available for the founder. So, this is a provision that can entice investors to provide capital, but it can also dilute future proceeds for common shareholders.
No one likes the sound of dilution, but a diluted entrepreneur with capital is likely to add more value to their company than a non-diluted entrepreneur determined to bootstrap their way to an IPO. This is the reason dilution isn’t always a bad thing; a smaller slice of a bigger pie is often better than getting a small pie all to yourself. However, don’t sign off on a term sheet without reading it – you could end up with nothing in a liquidity event. Even though there is a conflict of interest between founder and VC, in many cases a healthy balance can be found to protect both parties’ shares.