Dilution Protection

Okay, we are inside of the beaded walls of StartUpVille and there’s a disagreement revolving around the vision that two parties see in their crystal balls. The founder: Rose Colorglasses, the visionary behind Brain Planes, her telepathically controlled flying car company. Her vision of the future? Flying cars everywhere in just two years. She thinks that her first round of investment capital is a bargain at a dollar a share…and she is certain that the next round of investing—which she expects to happen in two years—will be at 10 dollars a share.

So that’s the vision of Rose Colorglasses…very fast uptake in demand for telepathically controlled flying cars, no big regulatory hurdles…no major accidents, and no headaches. But the vision of Manny Milesonhistires is very different. He thinks that the dollar a share he’s investing at is a gift—way too rich; it is a very high price to pay for a stock with zero proven track record. Manny believes the long term vision that telepathically controlled flying cars are the future...he just believes that it’ll take longer for the masses to adopt this new way of doing things and iron out the bugs.

Manny thinks that Rose will miss all of the financial projections she has made on her projected income statement. Normally he’d just wait until the next round to then invest likely at a cheaper price, but he knows that if he doesn’t invest now, he’ll be iced out of the next round, which he thinks will be at 50 cents a share. So to protect his shareholders—the people who gave Manny the money to invest on their behalf in the first place—Manny gets an anti-dilution provision in his contract. That is, he invests at a dollar a share to buy ⅓ of the company. A million shares. A buck each.

Then time passes. Doo doo doo doo doo doo doo doo. Sure enough, cars do crash in to trees. Cars crash into each other. And well, texting and driving? Very bad idea. And of course, Rose is forced to do the next round of funding...sheepishly at 50 cents a share. If there were originally two million shares of common stock that belonged to Rose as the founder, and Manny bought one million of them for a dollar...with the company now raising 1.5 million dollars at 50 cents a share, the company would have a total of six million shares outstanding.

The original three million shares in the first round, plus three million shares now at 50 cents each. But Manny originally bought ⅓ of the company for his million bucks for a million shares. Manny still owns the million shares he bought at a buck each, only now his ownership stake has been massively diluted. He owns one million out of a total of six million shares outstanding...or ⅙ of the company—way down from the ⅓ he originally bought.

His current stake is roughly just 17% of the company. So his anti-dilution provision kicks in and his original million bucks gets essentially re-priced to the 50 cents that the new round was set for.

So what happens? Well, basically he is issued more shares to “true him up” to owning ⅓ of the company again. He had bought a million shares, owned one out of six million, and to be undiluted, he needs to own two out of six million. Or said another way, Rose is forced to print more shares to give to him so that he owns ⅓ of the company. With this second round, the company has six million shares—if another million is printed and given to him, then he’d own two million shares—but there would be seven million shares now outstanding.

So…depending on how brutally the antidilution contractual language was written, Rose might have to print even more shares to cover his anti-dilution clause. And note in all of this just how much Rose has now been diluted: from owning 100% of the company the day she started it…she now, after just two rounds, still owns her two million shares that comprised all of the company at the beginning...only now there are some seven million plus shares outstanding, and likely many many more to come.

Of course, none of this'll matter if the flying car biz doesn't take off…or maybe takes off a little too quickly, if you catch our drift.