Dilution is an unavoidable aspect of any business that participates in multiple levels of investment financing.
With each new round of investment, the issuance of additional stock results in decreased equity shares for the initial investors, unless they are willing to participate in subsequent investment rounds at a prorated level.
The potential for dilution is especially problematic in down rounds of financing. In a down round, new shares of stock are issued at a price that is lower than the price paid by initial investors. If a VC purchased shares of stock at $2 per share during the initial investment round, a down round issue at $1 per share would result in both a loss in share value ($1 per share) and a loss of equity value because the additional shares would dilute his equity percentage.
To protect themselves, VCs insert antidilution clauses into the investment contract. These clauses fully or partially inoculate investors against the dilution that occurs during subsequent investment rounds. Unfortunately, founders don't enjoy similar protection against the effects of dilution. When down round funding occurs, the antidilution measures that protect investors mean that the founders and common stockholders bear the brunt of dilutive forces.
But that doesn't mean that company founders don't have options. Here's our take on how founders can survive down round equity dilution:
- Seek incentives. A founder who has experienced significant dilution is neither happy nor motivated. Yet the founder is expected to be the heart and soul of the company, the one with the passion to drive the company toward progressive levels of growth. Since an unmotivated founder makes for a bad investment scenario, VCs have an incentive to remotivate founders with stock options, bonus incentives, and other perks that compensate for down round dilution.
- Explore options. Down round financing probably isn't your company's only option. It may be possible to obtain bridge financing or secure other funding to accomplish the same thing. But depending on the terms of the investment contract, VCs might not have an incentive for avoiding down round financing. If that's the case, you'll need to be the one beating the drum for other funding alternatives.
- Start with a better deal. One of the mistakes founders make is to jump on the first investment deal that comes along. VCs are in it to make money and protect their interests. If you don't know what you're doing, you can easily give away the store through full ratchet antidilution clauses and other provisions that favor investors. Be smart – negotiate weighted ratchet antidilution clauses and other provisions that distribute the impact of dilution between you and your investors.