Dilution and Investors and Tension

I am going to try to address a complex problem in a concise way.

Here is the big problem with investors – they dilute the founders’ ownership in the company.  Is this actually a big problem?  Well, that answer depends on your point of view.

Let’s cover some basics:

  1.  It is impossible to issue stock to investors without existing shareholders (founders, employees and prior investors) being diluted.
  2.  It is impossible to do a stock for stock business combination without existing shareholders being diluted.  But now the diluted shareholders own a smaller piece of a larger pie hopefully.
  3.  If you have issues with dilution then raising outside investment will give you heartburn every time.  That is not a good situation to endure.

Given the basics, here is one key subjective data point that I always like to keep in mind:  what exit value is going to make the founders happy?.  The answer to this question is a function of (i) how much of the company do the founders own at time of exit and (ii) the exit value.   For example, a company may sell for a relatively small amount, say $18 million.   Are the founders happy?  Well, if they own 50% of it they well might be.  Typically, 50% ownership would mean that the company only has raised 1 or, at best, 2 rounds of equity funding.  Alternatively, if the founders own only 15% then they might not be too happy with an $18 million exit.   But they might be really happy with a $100 million exit.

Here is another basic truth:  the more a company raises, particularly in tough times when projections are not being met, for example, the greater the likelihood of real tension between the investors and the founders.  As investment dollars increase, founders ownership decreases.  And if dollars are raised in challenging times then valuation and other terms will favor the investors compounding the tension.  VCs deal with this situation most of the time.  The “up and to the right” valuation scenario is not at all common (unfortunately!) or only comes after millions and millions of investment.

It is up to the investors and founders to acknowledge the tension, discuss it and come up with solutions that dissipate it.  Often times, investors face situations where they must support a company that is going through growing pains.  These are tough times for the investors and founders.  It is up to the founders and investors to make sure that the founders stay motivated.  But it is up to the founders to acknowledge the situation the company might be in, particularly if sub-optimal.  There are ways to keep management teams motivated – additional stock option grants and management carve out plans are probably the 2 most common.  But the investors and founders need to have direct face to face open and trustworthy discussion.

The motivations of founders and investors are highly predictable and usually aligned (maximize company value!), which should make the discussion easier.   Luckily, the motivations are not political – I have been watching House of Cards recently…….

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