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How are my options protected from dilution over time?

Just got a job with what I think is reasonable equity but I know we're raising more capital soon. How should I discuss how my options are diluted over time?


10 Replies

Tim Scott
2
0
Tim Scott Entrepreneur • Advisor
President, Lunaverse Software
Your equity (and hopefully everyone else's) will be diluted proportionally to new equity issued. You have no choice but to trust that the executives deciding to issue new equity will get in return for it something (cash, talent, etc.) that will increase the value of the business proportionally (or better). Your percentage goes down, but as long as they don't make a bad deal, your absolute value does not.

The only reason you would seek some kind of "non-dilution" term is if you think they will make bad deals. In that case, you have a bigger problem. If you manage to get some kind of non-dilution terms, then you also have a big problem: the business will find it very difficult to raise funds. An investor will not be so keen to write a check for $10 million if he knows that x% effectively goes straight into the pocket of some existing shareholder.

You (and all other shareholders) should be more concerned with whether your shares are put behind the new shares in get cash out (liquidity preference). Again you have little choice but to trust those making the deal. That said, as a shareholder I would not hesitate to inquire about the terms of the raise.
Steve Everhard
0
0
Steve Everhard Advisor
All Things Startup
Of course Tim is right - a lower %age of shares at a higher valuation is potentially more valuable. It's all woofle dust if you don't IPO or get acquired or if you leave before the shares vest, just to put the whole thing in perspective.

You're only negotiation point really is that your options dilute at the same rate as ordinary shares on investment, often termedpari passu.
Rob Underwood
0
0
Rob Underwood Entrepreneur • Advisor
Advisor and Entrepreneur
It is possible (though usually hard) to negotiate anti-dilution protection for yourself and/or other senior executives, though that usually has to be done very early in the life of a company and will be something VCs will push back on and/or be a reason for them to walk away.

Re "what I think is reasonable equity", do you know what percentage of the company at its current valuation your options represent? The number of options is immaterial as it all depends on the denominator of total shares. What matters is how much of the company you could potentially own.Along with your salary you should know that number cold, and understand how it's changing (e.g., being diluted) through each fundraising round.

Tim and Scott are on point in their comments.
Keith Peer
0
0
Keith Peer Advisor
Chief Operating Officer at Certified Security Solutions (CSS)
Chloe,

As the entity raises more capital the dilution will increase for the initial investors/employees. It is very difficult to raise more capital without diluting the shares. The amount of dilution changes based on the amount sought during the capital raises and term sheets approved. Unless you are on the BoD you have little to no control in how your equity will be diluted over time. Also, the value of the equity is constantly fluctuating based on current speculative value of the entity. The equity is typically only valuable in startups when an event occurs, either IPO or acquisition. In rare cases will your equity be valuable before an event in a startup -- Keith
Tim Scott
1
0
Tim Scott Entrepreneur • Advisor
President, Lunaverse Software
I want to elaborate on my previous comment about "straight into the pocket of some existing shareholder," because it seems people often misunderstand the basic math of it.

Consider the following naive example.

You and four friends start Acme Widgets and each put in $100 in exchange for 100 shares. Now each founder owns 20% of a company with a book value of $500. Since you've created nothing yet, your market value is also $500.

Then along comes an investor willing to put up $250 in exchange for 250 new shares. The investor now owns 33% and each founder has been diluted down to about 13%.

Let's say some catastrophe strikes, and Acme goes bust the day after the funding closes. Assuming no special liquidation terms, the cash account will be liquidated and everyone will get back exactly what they put in.

But let's say you alone were able get a non-dilution clause. At liquidation, as if by magic, you've made a neat gain of $50. Your gain comes as a loss to the other shareholders'. Exactly who's loss depends on your non-dilution terms.

Obviously the math is never quite so simple in a real startup. Market value diverges from book value. Equity is given for intangible things. But this basic formulation remains true.
Rob Gropper
0
0
Rob Gropper Entrepreneur
Director at PetHero, SPC - Member at Eastside Incubator - Principal at Tuxedo Technologies Group
@ Tim, correct me if i'm wrong, but the new investor should own 33% - 250/750 total shares and the original founders would each be diluted to 13% (100/750)?
Tim Scott
0
0
Tim Scott Entrepreneur • Advisor
President, Lunaverse Software
@Rob Ahhhh. Yeah, I started with different numbers and missed an edit (33% from 25%). I updated it online. I guess when you're giving a lesson on basic math you should get the numbers right!
Don Ross
0
0
Don Ross Entrepreneur
Managing Partner Digital Health at Life Science Angels
Tim, the cap table math still needs some adjustment.

Start: "You and five friends start Acme Widgets and each put in $100 in exchange for 100 shares." I take this to mean 6 founders with 100 shares each for a total of 600 shares.

"PREMONEY CAP TABLE"
Person shares % ownership
Founder #1 100 shares 16.67%
Founder #2 100 shares 16.67%
Founder #3 100 shares 16.67%
Founder #4 100 shares 16.67%
Founder #5 100 shares 16.67%
Founder #6 100 shares 16.67%
TOTAL 600 SHARES 100% (rounding from 100.02%)

NEW INVESTOR PURCHASES 250 SHARES:
"Then along comes an investor willing to put up $250 in exchange for 250 new shares."

"POSTMONEY CAP TABLE"
Person shares % ownership
Founder #1 100 shares 11.76%
Founder #2 100 shares 11.76%
Founder #3 100 shares 11.76%
Founder #4 100 shares 11.76%
Founder #5 100 shares 11.76%
Founder #6 100 shares 11.76%
INVESTOR 250 shares 29.41%
TOTAL 850 SHARES 100% (rounding from 99.97%)

Cap tables usually run out to 4 decimal places to cut down on the rounding.

Hope this helps.

Tim Scott
0
0
Tim Scott Entrepreneur • Advisor
President, Lunaverse Software
@Don Ugh, I'm a disaster! I meant four of your friends (five total). Edited original.
Trevor Power
2
0
Trevor Power Advisor
Business Development Manager at Warwick Ventures Ltd.

Possibly a bit obvious, but it might be worth considering what constitutes a 'bad deal' in the context of Tim's original post. I'd expand this into a 2-part concept and suggest that you want to be confident that the leadership of the company can (a) use the investment raised to create value and (b) negotiate to realise that value in subsequent investment rounds.


To protect the value of your stake,you want to be sure that the pre-money value of each investment round is greater than the post-money value of the previous round (not just pre-money to pre-money).


In the example above (assuming +4 friends!)at the completion of the first investment round the investor has 250 shares and the 5 founders have 100 shares each, all valued @ $1.

  • Premoney value $500 (which comes from the value agreed per share in this deal)
  • Investment $250
  • Postmoney value $750

If you're a founder, your stake is worth (on paper, at least) $100.

Now assume that you need to raise $500 to fund the next stage of growth.


Let's say that you find an investor who's willing to fund that at a pre-money value of $1125 - i.e. a share price of $1.50 * the 750 shares then in issue.


Now your stake as a founder has fallen from 13% to 8%, but your 100 shares are worth $150. The first investor is diluted from 33% to 20%, the new investor has a 40% stake and the company has a post-money value of $1625.


Hence the need to see a steady increase in value from the post-money value of each round to the pre-money value of the next, which also gives an indication of the efficiency of the company in converting investment capital into value.


So in and of itself, dilution is not necessarily a problem,although it can be an issue where a shareholder or group of allied shareholders are diluted past a control threshold.


It is worth noting that in practice many companies have preference shares in their capital structures, and these can have a very significant impact on the returns to ordinary shareholders in a liquidation event.

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