The Price of Growth: Founders’ Dilution

Opinion

Founders of a company considering the various available fundraising options often ask the challenging question: Why take venture capital money, which may significantly dilute the founders and might result in a loss of control of the company? Although the venture capital path is always a possibility, founders are often concerned about the consequences of such investments.

There are many benefits to obtaining venture capital financing, including:

  • immediate access to a significant amount of capital;
  • potential access to additional funds held in reserve by the investors for future rounds of financing;
  • access to the investors’ expertise, experience and network;
  • immediate credibility in the marketplace; and
  • ability to hire key employees, bringing increased credibility in the job market, thus allowing the company to ramp up quickly and beat the competition to the market.

Assuming the founders have determined that the benefits of venture capital financing outweigh the risks, they must expect and understand the dilutive effect of multiple rounds of venture capital financings. Founders should appreciate the importance of negotiating the economic terms of a financing as illustrated in the examples below.

Series A Financing

Perhaps the most highly negotiated business term for a venture capital financing is the pre-money valuation. A lower than anticipated valuation is often a challenging issue for founders to overcome, as it can be difficult for founders to look long-term and appreciate the potential benefit of owning a small percentage of a very successful company. However, often the difference between failure and success is a company’s ability to go to market quickly. In order to do so, companies need access to capital to hire employees. Taking venture capital money can provide founders with access to that capital.

For the sake of this article, let’s assume a pre-money valuation of $4 million for a company undergoing its first round of venture capital financing. If the investors funded $4 million, the resulting post-money valuation would equal $8 million and the investors would receive 50 percent of the company. In this scenario, founders often think that they would own the remaining 50 percent of the company post-closing. However, depending upon the current composition of the management team (and the equity positions of each member), investors will expect an option pool to be implemented prior to closing for future issuances to new hires. This option pool is established prior to closing so that the investors are not diluted. Although the size of the option pool is subject to negotiation, a typical option pool might reserve 20 percent of a company on a fully diluted basis. Therefore, in the above example, instead of the founders owning 50 percent of the stock after the Series A closing, the founders would own 30 percent of the equity on a fully diluted basis (with the investors owning 50 percent and 20 percent reserved for the stock option pool).

Another significant business term negotiated with the initial round of venture capital financing is the vesting of the founders’ equity. The above example states that the founders own 30 percent of the stock on a fully diluted basis. However, this percentage assumes that 100 percent of the founders’ stock is vested. Although the specific vesting terms can be negotiated, most investors will require that founders’ stock vest over a period of time (often over four years). When a founder leaves the company, the company will have the right to repurchase the unvested shares from the founder at a nominal price (typically the price at which the founder purchased the shares). If founders have contributed significant “sweat equity”, and have been employed by the company for some time prior to the financing, the investors may agree to vest some of the founders’ shares upfront and effectively give the founders “credit” for their past efforts. The investors may also agree to accelerate the vesting of a portion or all of the shares upon a change of control or if a founder is terminated by the company without cause prior to a change of control.

Based upon the above example, after the Series A round of financing, the following represents the equity distribution:

Group Pre-Series A Post-Series A
Founders 100 percent 30 percent
Series A Investors 50 percent
Option Pool 20 percent


Liquidity Event

How the consideration on an acquisition is divided among equity holders can vary significantly depending upon the terms of the preferred stock. Using the above scenario in which a company has raised $4 million of venture capital financing, let’s examine two different potential outcomes: a sale with net proceeds to stockholders of $5 million and a sale of $10 million. The analysis below assumes that all debt, investment banking fees, legal fees, and other obligations of the company, which must be paid at closing prior to any distributions to stockholders, have been paid and are not included in these amounts.

$5 million sale:

Many companies eventually run out of internal investor support and have difficulty raising additional capital from new lead investors. One common path in this situation is a sale of the company if the company is not yet cash-flow positive and is not capable of raising more money. If a company has raised $4 million, a $5 million sale will not leave much for the founders as holders of common stock. Preferred stock terms will in almost all instances include a liquidation preference provision, which will allow the holders of preferred stock to receive their investment back first, before any cash is distributed to the holders of common stock.

In this example, the first $4 million will be distributed to the investors because of their liquidation preferences. How the remaining $1 million is allocated will depend upon several factors, including whether the … Next Page »

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Mary Beth Kerrigan, a partner with the Boston-area law firm Morse Barnes-Brown Pendleton, represents technology-based companies from formation to liquidity event, including advising clients with respect to angel financing, venture capital financing, and mergers and acquisitions. She can be reached at mbkerrigan@mbbp.com. Follow @MorseBarnes

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