Just say no to anti-dilution

by Kamal Hassan

I had a call yesterday from an entrepreneur, who asked me about an anti-dilution clause in a terms sheet they had been offered. My short answer to him was ‘just say no’. The slightly longer answer was ‘this typically reflects disagreement over valuation, so reduce your valuation’. This is a perfect example of my previous advice that terms matter much more than valuation.

(For those who don’t know, an anti-dilution clause is a clause added to a financing agreement which says ‘if new money is raised and your valuation is less than X, then all other shareholders need to give me shares or effectively give me shares’. They will own less of the company, and I will own the same percent of the company. So, for instance, if you own 8 million shares and I own 2 million shares I own 20%. If I have an anti-dilution clause, and a new investor puts in $500,000 in return for 5 million shares, then you have to give me 1 million of your shares, so I will still own 20%.)

The situation in the case of this entrepreneur was even more outrageous.   He is one of the final few people being considered for space in a European incubator. They will invest a small amount of cash, valuing the company at $250,000. However, they want an anti-dilution cluase that protects them every time you raise money in the future at a valuation of under $5,000,000. This is very unusual. I checked in with an EU investment banker I know to see what was going on, and his response was exactly what I thought: “Re anti-dilution clauses, I assume you mean down round protection? This is fairly common when buyers and sellers have a different view of valuation.”

To elaborate, if you think your valuation is $2M, and I think your valuation should be $1M, rather than arguing about the numbers, I will ask for ‘down round protection’. If you raise more money at a lower valuation, you need to transfer me as many extra shares as I would have received if I had invested at that lower price.

This incubator isn’t asking for ‘down round protection’ though. Their anti-dilution provision is saying “we think your company is only worth $250,000 … but we want to be ‘protected’ if your next investors think your company is worth less than $5,000,000”. This is ridiculous. Let’s put that to the side for a second. My advice to them was still to trade off valuation for that clause. If the incubator thinks you are worth $250,000 with an anti-dilution clause, then what are you worth without it: $200,000? Fine, dump the clause and reduce your valuation to $200,000.

Why is this so important to do? Think about it from the point of view of your next investor, who in all probability is not going to be a venture capitalist offering a $5M valuation. They really don’t care about your early investors. The early investors gave you money to get to this point. The people who will take the company further are management. They get annoyed when management has to transfer more shares to early investors as a condition of their investment. They want their money kept in the company to help it succeed, and they want to see management motivated to keep working hard: they don’t want to see management’s shareholding reduced to benefit ‘non-contributors’.

Some future round investors may play hardball in an attempt to get this clause taken out. Some may just say ‘your cap table is too messy’ and walk away. None of them will like it.

The messaging of an anti-dilution clause is very suspect. It says ‘the entrepreneurs who gave it are naive/foolish/too focused on valuation’ and ‘the investor who asked for it is greedy/untrusting/taking advantage’.

Either the investor is taking advantage of the entrepreneurs, who don’t really understand what the anti-dilution clause means; or the entrepreneurs were too greedy and focused on valuation above terms; or the investor has been burned in the past by entrepreneurs and thinks adding onerous terms to all entrepreneurs will protect them: the good people pay the penalty for the bad (this may reflect a lawyer-driven approach rather than a business-driven approach).

Another thing an anti-dilution clause does is give people divergent interests. This means they may start arguing with each other rather than working together. How do interests diverge?

Let’s say the company starts to run short of money. A ‘bottom-feeder’ investor may come along and offer you $50,000 in return for 80% of your company. If nobody has an anti-dilution clause, everyone will look at that deal and say ‘yuck, let’s find a better option’. If someone has anti-dilution, they could think ‘well, this deal won’t hurt me, and the company is better off with the $50,000 than without it, let’s do the deal’.

Running a business is hard enough, you don’t need internal battles as well: keep everyone’s incentives aligned, and just say no to anti-dilution.

So, what do you do when someone tries to force an anti-dilution clause on you?

My advice is the same as before: say ‘clearly you think the valuation of our company is too high: what is the valuation you would accept to drop the anti-dilution clause’. This way you will keep a cleaner cap table, run your company more smoothly, and be more ready to take in money in the future.

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