Anti-dilution seems to be one of the first concepts that comes up in ‘laymen’ conversations about start-ups and early employees. I always have visions of wizened fathers giving advice to children who are about to take a job at a start-up: “make sure that they give you that anti-dilution…then they can’t screw you!!”
Yes, there is such a thing as anti-dilution clauses. The VCs get it and so why shouldn’t you get it, too? However, channeling my inner Inigo Montoya: “I don’t think that word means what you think it means.” The anti-dilution that managers tend to be asking for – because it’s the only construct of anti-dilution that makes sense around options and common stock – is, “if I get a stock grant for 1% of the company, no matter what else happens, I’ll always have 1% of the company.” Now, I’m sure that somewhere, at some time, some company (either for a Jobs-ian rock star executive or, conversely, out of sheer ignorance) has agreed to an arrangement like this. Still, I’ve never seen it. And you should know that I also believe that somewhere there are unicorns.
We've already allowed that VCs get anti-dilution protection. What is it that they are getting? The clause “anti-dilution” in investment documents is actually a form of price protection. It says that if someone later invests at a cheaper price, then the price the previous investors paid adjusts downward either to the new price (that’s called “full” anti-dilution) or to a place in-between, depending on the relative size of the new round (that’s called “weighted” anti-dilution). After giving effect to the new capital, anti-dilution clauses can result in greater ownership for the old investors, the same or less. It’s worth noting that anti-dilution clauses are also frequently waived because the new investors who have negotiated the lower price generally have lots of leverage and will say, “ahhhh…no. Anti-dilution clauses just mean the management pool is suffering the bulk of the dilution in this round and so soon we’re going to have to increase the option pool to protect management, ultimately transferring the dilution to….me.”
So we’ve seen that anti-dilution clauses are an imperfect tool to prevent dilution. But the idea of protecting one’s ownership stake is a concept that has definitely occurred to professional investors. And, in fact, it’s probably the most important right that investors typically have, even though its discussed far less frequently. It’s called “pre-emptive rights.” Say you own 10% of a company. Pre-emptive rights will give you the right to purchase 10% of any new offering. By so investing you will, in fact, preserve your ownership stake (almost exactly...can be some wiggle room around what's counted).
Before you jump out of your chair and scream, “so VCs do get to preserve their stake!” note that this is still a very different concept than, “I’ll always have 1%...” This is the opportunity to keep writing checks. Unfortunately, that’s a hard concept to apply to option holders for whom the major benefit is the ability to not write any checks until the end of the dance.
Given all of this, what should you ask for as a key employee at a start-up? First, understand your own preferences…are you willing to trade cash for more stock? Then, ask for as big a grant as you think available given those preferences. Ask for a reasonable amount of transparency. Very rarely do companies share their capitalization table feely, but you can generally get some sense of where the company is at. Most importantly, ask about the price, especially whenever there is a new round. The key to value creation is price appreciation. Due to the way preferences work (see this post to better understand preferences), even a big stake isn’t going to be worth anything if the price isn’t rising.
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