Don’t Hate On Your VC For Exercising Anti-Dilution Provisions
Categories: Venture Capital
There’s a lot of talk about down rounds now in the venture capital industry since valuations are down. So I suspect a lot of venture-backed companies are dusting off their Series A Preferred Share Agreements and taking a look at the anti-dilution provisions held by their investor(s).
But should your founding team be offended if your venture capital firm exercises its dilution protection provisions when your startup goes through a down round? In a word: No. But many times founders are upset with their VC when their VC exercises anti-dilution provisions.
Of course, dilution is an understandably upsetting event for founders. They worked extremely hard and risked everything to get that $5,000,000 pre-money in the Series A round, but now due to various factors, they need more cash and will get lower valuation in the Series B than they got in the Series A. After the initial investor exercises its anti-dilution provisions, the common stockholders will be left with even less equity in the startup.
But being upset about the dilution doesn’t mean you should be upset at your VC.
First, the anti-dilution provision was part of your funding. You accepted it and to some extent you should be accountable. Even if your late round financing would only be nominally dilutive to your investor, such anti-dilution protection was a material term in getting funded in the first place. Sure, anti-dilution protection can seem like a huge equity squeeze to the common stockholders, but no one forced the startup to take the investor’s cash.
Second, keep in mind that the venture capital firm (through its fund) has limited partners (and fiduciary responsibilities thereto). Venture capital firms are in the business to provide great investment returns for their limited partners. By exercising the anti-dilution provision, the venture capital firm is hoping that the larger amount of shares will help the venture fund improve its return to THEIR investors. (And if they can’t improve their return to investors, the investors will stop investing with such a firm.)
I would agree, however, if a VC exercises anti-dilution provisions inappropriately… I would consider it reasonable to be more-than-ticked-off (and yes, at the VC).
If a company needs to raise more funds, due to an unforeseen event (say, spurred by this economy)… then it's in everyone's interest to dilute the company, rather than own shares in a broke(n) company.
A VC that owns 20% of a bankrupt company is almost never going to be as valuable as owning 15% of a company that is profitable. When you bring on a VC, you're expecting to have a funding partner, not someone that poorly acts on their rights.
But, you are right, a lot of start-ups took money like candy (much like in the sub-prime mortgage crisis we're also in now) and didn't read the fine print (much less have a team that could understand it). And now the VCs are defending themselves and asking the other shareholders to dilute their shares instead. My point on that angle is, sometimes that isn't an option… especially as a startup gets closer to market.
By the way, I'm speaking as a start-up owner that has gone bootstrapped so far, not really as someone in a position to be ticked at a VC anyways.
Since this article was rather light on real advice (no offense, you do raise some good points), I'll give some more advice to startups in this position. If a VC does shoot down the concept of diluting initially… go back to them with a better picture of how dire things are. Obviously a startup doesn't ever want to dilute… so show your VCs what they're risking by blocking the dilution.
I would agree, however, if a VC exercises anti-dilution provisions inappropriately… I would consider it reasonable to be more-than-ticked-off (and yes, at the VC).
If a company needs to raise more funds, due to an unforeseen event (say, spurred by this economy)… then it's in everyone's interest to dilute the company, rather than own shares in a broke(n) company.
A VC that owns 20% of a bankrupt company is almost never going to be as valuable as owning 15% of a company that is profitable. When you bring on a VC, you're expecting to have a funding partner, not someone that poorly acts on their rights.
But, you are right, a lot of start-ups took money like candy (much like in the sub-prime mortgage crisis we're also in now) and didn't read the fine print (much less have a team that could understand it). And now the VCs are defending themselves and asking the other shareholders to dilute their shares instead. My point on that angle is, sometimes that isn't an option… especially as a startup gets closer to market.
By the way, I'm speaking as a start-up owner that has gone bootstrapped so far, not really as someone in a position to be ticked at a VC anyways.
Since this article was rather light on real advice (no offense, you do raise some good points), I'll give some more advice to startups in this position. If a VC does shoot down the concept of diluting initially… go back to them with a better picture of how dire things are. Obviously a startup doesn't ever want to dilute… so show your VCs what they're risking by blocking the dilution.
It also means they still believe in the investment. Any founder would have far more grounds for concern if their VCs chose NOT to participate in a down round.
It also means they still believe in the investment. Any founder would have far more grounds for concern if their VCs chose NOT to participate in a down round.
@Christopher- Hey no offense taken. I was just trying to point out some perspective to startups. I hear a lot of startups complain about VCs before they even get started.
And you are right, there is potential for negotiation regarding the exercise of dilution protection. Investors don't want to eliminate or reduce founders/management's incentive to work. While the founder-VC relationship can seem adversarial, the founders will get the most out of the relationship if they view their VC as an ally rather than a "vulture capitalist." Thus, open communication like you suggest is invaluable.
@Christopher- Hey no offense taken. I was just trying to point out some perspective to startups. I hear a lot of startups complain about VCs before they even get started.
And you are right, there is potential for negotiation regarding the exercise of dilution protection. Investors don't want to eliminate or reduce founders/management's incentive to work. While the founder-VC relationship can seem adversarial, the founders will get the most out of the relationship if they view their VC as an ally rather than a "vulture capitalist." Thus, open communication like you suggest is invaluable.