Early Employee Dilution

I recently got a question from a person in a large company who is thinking about joining a startup that expects to raise venture capital.  Actually, I got many questions.  But here is one that I want to focus on in this post:

“Can I ask for undiluted stock (non dilution clause)?”

To use Brad Feld’s expression, this question kind of gave me a “vomit moment”.  The short answer is that no one should ever ask for this type of protection.  The longer answer is:

1.  I am not even sure what “undiluted stock” is, but safe to say the person (I will call him Exec X) meant stock that his equity would not be dilutable in terms of ownership.

2.  It is legally possible to grant non-dilution via a contractual right.  For example, let’s say Exec X is asking for 10% of the fully diluted cap table via a stock grant or option grant that is non-dilutable.  He is asking for 10% because he is joining as a high level officer like CEO or COO and he is a very early employee.  The company could grant Exec X a right to receive more stock (or more likely stock options to avoid tax issues) as the company issues additional equity in the future.  Those additional grants would prevent Exec X from being diluted.

3.  But, the problems with doing so are numerous.  First, it means that every time the company issues more equity, the other stockholders (most notably the founders) are going to be diluted again by this “non-dilution” issuance to Exec X.  So, the founders get diluted by the triggering equity issuance (like a financing) and then they are diluted again by Exec X’s non-dilution protection.  That is an untenable result and really stinks for the other shareholders.

4.  Second problem:  it raises a huge red flag for investors.  Not only will the investors ask why on earth did the founders grant Exec X such a right, but they will also ask why on earth did Exec X ask for such a right.   It will spook the investors.  They won’t (or should not) tolerate it and will end up making Exec X give up this right going forward.  Not a great way to start a relationship.

5.  Third problem:  the right given to Exec X gums up the company’s cap table.  New investors would have to build in the “non-dilution” shares into their valuation per share calculation.  This will create headaches and investors will not like dealing with it.

This is not to say that Exec X won’t ever get an additional equity issuance in the future.  For example, if the company raises lots of $$ and Exec X’s ownership drops to say 3% ownership over time, then the Board of the company would likely grant Exec X options to get him back to a “CEO level”, which is typically 6 – 8%.  It will all depend on Exec X’s performance.  For that matter the Board could also replace him……

Happy to entertain your questions.  Thanks.