Creating value through dilution
Wednesday, June 25, 2008/
Ask the founders of Google if they’re happy with their minority position and I’m sure you won’t hear too many complaints. DORON BEN-MEIR
By Doron Ben-Meir
“I’d rather have 10% of a big pie than 100% of nothing…”
You convince yourself of all the benefits but there is still a nagging feeling of insecurity as you bring in your first professional investor.
The anticipation of success… the fear of losing control… the stress associated with giving up a substantial slice of equity…
When one considers most large scale successful enterprises, the original founders typically no longer have a majority interest. Ask the founders of Google if they’re happy with their minority position and I’m sure you won’t hear too many complaints.
Provided you’ve chosen competent investors that understand your business, dilution is a mechanism for value creation – but there are legitimate concerns.
Often entrepreneurs equate shareholding with control and so see dilution as simply a means by which investors take control of their business.
For founding executives whose contribution is deemed essential for business success, there are a couple of simple mechanisms that can be employed in order that their enthusiasm is maintained and their interests remain aligned with the investors – even if the nominal dilution they suffer is significant.
We had experience with a deal where the two founders raised a substantial sum at a relatively low pre-money valuation leaving them with only 30% of the company between them after series A. They were naturally concerned that they no longer controlled their own destiny.
To align their interests with ours, we provided them with some of the same veto rights (for substantial corporate decisions) that VCs typically take when they are in a minority position. This reintroduced certain powers for the founders and demonstrated our belief in their contribution and judgement. While these powers were not determinative, they were blocking powers and so engendered a strong feeling of trust.
As the deal matured there was an opportunity to expand into the US for which a much larger round was required. This round reduced the founders to a very small equity level.
As the founders were key executives, the investors topped up their equity through the executive share option plan to ensure that the key people in the business had a substantial holding – an important issue for third party acquirers or underwriters when contemplating an exit.
The founders then lost their veto powers but by then the enterprise value had risen substantially and a highly professional board was in place – giving the founders comfort that they had largely succeeded in their value creation efforts.
It always comes back to alignment of interests. This should be the test of any investment model for both founders and investors. Provided the alignment is convincing for both parties, dilution is nothing to fear.
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Doron Ben-Meir has been an active venture capital manager for the last eight years. He founded Prescient Venture Capital and prior to that was a consulting investment director of Momentum Funds Management. He was a serial entrepreneur over a 12 year period, co-founding five new technology based businesses.
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