The Price of Growth: Founders’ Dilution
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|
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 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.