In a perfect world, an entrepreneurs could build a successful company and sell for 100% of the profit. In another perfect world, an investor could invest a Series A and receive 15 per cent cut of the exit.
Unfortunately, this is not a perfect world and Founders must always give up pieces of the company and investors will see their stake dilute.
Dilution is a fact of life in startup world, but it’s also a topic that often leads to conflict, dispute and antagonism.
At e27 Academy, Fernand Lendoye the Managing Director at Aviva Ventures, broke down how these legal terms can help — or hurt — a company down the line.
The key theme of the talk is this: If an investor is keen to provide money, they will work with you to create the best contract possible. This means, for an entrepreneur, it is important to understand where they can negotiate, battles to skip and red lines that cannot be crossed.
If both sides come into a deal with honest intentions, acting in this manner will not blow up the deal and actually should give the investors more confidence that this is a positive relationship moving forward.
Let’s have a look at a few of the terms mentioned by Lendoye and how Founders can approach them around the negotiating tables.
How to think about anti-Dilution clauses
Anti-dilution clauses are designed to protect investors who provided the initial funding that kickstarted the company’s growth.
Terms typically come in two tranches, full-ratchet clauses and weighted-average clauses. There is also the possibility that an investor has no dilution clauses, but that could signal a lack of experience on the part of the investor.
Anti-dilution clauses protect the proportional shares an investor holds in the company so that a Series A investor does not see their returns become worthless as the company moves to Series B, C, D etc.
Weighted-average clauses are essentially “marks” whereby share prices take into consideration previous investment rounds and what is currently being raised. This is especially important in a down-round (when a company loses value). The reason is because without Weighted-average clauses, an investor can buy cheap shares and dilute the stake of older investors who had actually paid more for the stake and are suddenly owning less of the company.
If a company pursues a “this is the price” strategy, then that is called a full-ratchet clause. In this case, if a company raised its Series A at a price of US$100 per share and then loses value, it will issue shares at US$75 during the Series B.
The result of this strategy is a Series B investor can now buy shares at a 25% discount and scoop up more bang for their buck.
Now, the headache caused by a full-ratchet triggering is clear. A company may suddenly be dealing with a toxic investor relationship and will need to navigate choppy waters.
However, that’s a secondary concern to the problems it can cause the Founders.
Why this is bad for Founders
The blunt answer is that it can create a situation whereby a Founder does not make money off an exit.
Oftentimes, as the fundraising process moves along, investors introduce liquidity preference language that results in the VC getting their money back in an exit. Even if they don’t make money, they won’t lose money.
This means that there are situations whereby, after the Founder has paid back all of the investors, completed the ESOP plan and there is very little money left for the entrepreneur. Sure, they may own 20 per cent of the company, but 20 per cent of zero is still zero.
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As a Founder, and holder of the original equity, weighted-average clauses help protect the equity preference and ensure the Founder receives their payday.