The Price of Growth: Founders’ Dilution

Opinion

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preferred stock is “participating” – i.e., whether the holders of preferred stock receive their money back first and also are allowed to participate on an as converted basis in the distribution of the remaining amount, or whether the holders of preferred stock only receive the greater of their money back or the amount they would have received had they converted to common stock immediately prior to the transaction.

If the preferred stock is participating, then upon a $5 million sale, the investors would receive $4 million plus $500,000 (50 percent of the remaining $1 million) for a total of $4.5 million, leaving the founders with $300,000 (30 percent of the remaining $1 million) and the option holders with $200,000 (20 percent of the remaining $1 million, assuming all founder stock and options are vested and, for simplicity’s sake, disregarding the exercise price of the options). If the preferred is not participating, then the investors would receive $4 million, the founders would receive $600,000, and the option holders would receive $400,000.

Another factor which could significantly impact the distribution of proceeds on the sale of a company is whether the holders of preferred stock have rights to dividends. Cumulative dividends paid out upon a liquidity event could significantly increase the amount distributed to the holders of preferred stock. If cumulative dividends were included in this company with an 8 percent annual return over 4 years for the Series A, then the dividends would increase the preference amounts payable to the preferred stock to $4.24 million for the Series A.

$10 million sale:

If the proceeds of the transaction are increased to $10 million, the amount to be distributed to common stockholders increases significantly and will continue to depend upon whether the preferred is participating and whether the preferred terms include dividends. If the preferred is participating (with no dividend), then the investors would receive $4 million plus $3 million (50 percent of the remaining $6 million) for a total of $7 million, leaving the founders with $1.8 million (30 percent of the remaining $6 million) and the option holders with $1.2 million (20 percent of the remaining $6 million, assuming all founder equity and options are vested and, for simplicity’s sake, disregarding the exercise price of the options). If the preferred is not participating, then, given the amount the investors would receive had they just converted to common stock immediately prior to the transaction, the investors would instead elect to receive their percentage on a fully diluted basis, with the investors receiving $5 million (50 percent of $10 million), the founders receiving $3 million (30 percent of $10 million) and the option holders receiving $2 million (20 percent of $10 million).

The above examples show the economic significance and impact of the preferred stock terms. Although some features such as participating preferred were once quite prevalent, founders often are able to negotiate better economic terms (such as removing the participation feature completely, or negotiating a cap on the liquidation preference, which the above scenarios do not contemplate).

Founders should always remember to weigh the importance of these economic terms and the many benefits of obtaining venture capital financing against other alternative financing arrangements which may be available to the company.

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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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