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.

I got into a discussion with a startup CEO recently and also one of my venture fund partners regarding directors of a startup having open access to all officers at the company.  This is a very delicate topic.

My mindset is that directors of a startup should be expected to talk with all officers of the company without “going through” the CEO.  I think the CEO should expect this to happen and should also encourage it.  I think the CEO should view this as a way to empower his/her team members.  I call this communication scheme “open access”.  Yet I actually know a number of CEOs who cringe instead at the concept.

I do have some basic assumptions that are critical for “open access” to work:

1.  The CEO runs the company day to day.  The other officers (COO, CFO, VPs, etc.) report to the CEO (there are infrequent exceptions when another officer (typically a co-founder) does not report to the CEO, but rather directly to the board; often this ends in $%^#show, and I don’t recommend it).

2.  So, having the board members have access to the officers requires that the CEO be comfortable with his/her position in the company and his/her level of respect with the board.  This is not always the case.  Confidence and security levels vary.  The need to control (whether justified or not) varies.  The ability to delegate correctly varies.  These facts add variables that board members need to acknowledge and deal with.  They are challenging variables.

3.  The directors have to have the proper skill set to handle the information that they receive from officers as a result of open access.   The directors should NOT be tasking the officers – that is the CEO’s job.  Rather, the directors should ask officers for their views on company culture, strategy, product development and related high level matters.  Then, proper use of the learned information is key.  Ideally it should produce honest discussion among all the board members, including the CEO when appropriate.

4.  Getting “inputs” by asking for views is critical.  The officers must understand that the directors are not trying to undermine the CEO by asking for input.  Rather the directors are trying to enhance how the startup functions.  One way to ensure this is to establish the “director to officer” communication channel very early and make it part of the normal governance procedures.  Simply, it should be expected.

5.  The “director to officer” communication channel does not need to be frequently tapped to be effective.  Perhaps a given officer has a conversation once every month or two with a director.  Again, these communications are empowering.  They are often ad hoc and not regularly scheduled.

So, I encourage you to practice open access at your startup companies.  And here is one more point to consider:  officers owe the same fiduciary duties to the company’s shareholders as directors do.  See this article for a good summary.  This means that officers have a duty to report up to board members and bypass the CEO when necessary (in other words when reporting up on issues concerning the CEO).  If an officer believes that a CEO is not responsibly executing, then the most sound course of action is to get the ear of a director to discuss.

More to come on this topic.  Look forward to your comments.