Insights18 June 20245 min

How to Protect Your Shares. Smart Fundraising Strategies | Monard Law

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A few years ago, three friends had a vision to change the world. They started NextGen Tech in their garage to make their idea real. Each founder holds an equal share of 1.000 shares:

Shareholder# of shares at incorporation% of shares at incorporation
Founder 11,00033.33%
Founder 21,00033.33%
Founder 31,00033.33%
Total3,000100.00%

After a year of hard work, sleepless nights, brainstorming sessions, coding marathons, and endless pitches, their dedication begins to pay off. The first customers sign up, and NextGen Tech's success takes off. They need more capital to scale up, so they start looking for investors. Of course, the founders want to give up as few shares as possible while getting the most capital.

As NextGen Tech has all the makings of a potential unicorn, investors line up to get involved. After careful deliberation, the founders struck a deal with the two venture capital funds that gave NextGen Tech the highest valuation.

Greed Ventures and Capital Ventures each invest 500.000€ in NextGen Tech, valuing the company at 2.000.000€ before this investment. At the same time, they set up an ESOP (employee stock option pool) with 500 shares to reward employees.

The founders sign the term sheet and investment agreement. They read the terms and conditions but don’t consider them very important. After all, they secured a significant investment without giving away too much equity and retained a majority stake in the company they had worked so hard to build. Sounds like a win, right?

The share division now looks like this:

ShareholderShares at Start%Shares after Series A Investment% Shareholders
Founder 11,00033.33%1,00020.01%
Founder 21,00033.33%1,00020.01%
Founder 31,00033.33%1,00020.01%
Series A Investor 174914.99%
Series A Investor 274914.99%
ESOP50010.00%
Total3,000100.00%4,998100.00%

Clouds appear on the horizon

However, two years later, NextGen Tech hits a rough patch. A competitor develops a more efficient product, product development stalls, and unexpected operational costs arise. Conflicts within the team start surfacing. NextGen Tech is still nowhere near break-even and the money from the first round is quickly running out. Desperately in need of funds to avoid bankruptcy, the founders find themselves looking for new investors in a much less favourable position.

After a long search, they find an investor willing to participate at the same pre-money valuation of 2.000.000€. This is a lot lower than the post-money valuation of the previous round, a so-called "down round" of investment. The series B investor agrees to fund 500.000€. After the down round, the cap table looks like this:

ShareholderShares at Start%Shares after Series A Investment% ShareholdersShares after Down Round% (Fully Diluted)
Founder 11,00033.33%1,00020.01%1,00016.33%
Founder 21,00033.33%1,00020.01%1,00016.33%
Founder 31,00033.33%1,00020.01%1,00016.33%
Series A Investor 174914.99%74912.23%
Series A Investor 274914.99%74912.23%
Series B Investor1,12418.36%
ESOP50010.00%5008.17%
Total3,000100.00%4,998100.00%6,122100.00%

Understandably, Greed Ventures and Capital Ventures are not at all happy about this development: they feel they overpaid for their shares. After all, they injected 1.000.000€ into a firm valued at 2.000.000€ at the time, only for it to still have that same value two years later.

This is where the founders discover the "anti-dilution protection" clause they had overlooked in their initial funding agreements. This clause protects the venture capital funds from losing the value of their investment during a down roud.

Applying the anti-dilution protection, the valuation at which Greed Ventures and Capital Ventures participate is corrected retroactively.

There are generally three types of anti-dilution protections:

  • Full Ratchet gives the initial investors additional shares to compensate for the price difference if a down round occurs, essentially putting them in the position they would have been if the initial investment was at the down round valuation.
  • Weighted Average uses a formula that considers the amount and valuation of the initial investment and the down round to determine a new average share price.
  • Broad Based Weighted Average considers all convertible securities like stock options when calculating the new share price.
  • Narrow Based Weighted Average calculates the new share price based on outstanding shares, excluding other convertible securities.

Unfortunately, the founders had agreed to the Full Ratchet method, the most investor-friendly option. Any anti-dilution method would have resulted in further dilution of their shares beyond the down round, but the Full Ratchet is the most radical of all.

This method gives the initial investors “free” new shares to bring them to the point where they would have been financially if the down round had used the same valuation as the initial capital round.

As a result of the Full Ratchet anti-dilution protection measures, the cap table now looks like this:

ShareholderShares at Start%Shares after Series A Investment% (fully diluted)Shares after Series B Investment% (fully diluted)Shares after Full Ratchet% (fully diluted)
Founder 11,00033.33%1,00020.01%1,00016.33%1,00014.55%
Founder 21,00033.33%1,00020.01%1,00016.33%1,00014.55%
Founder 31,00033.33%1,00020.01%1,00016.33%1,00014.55%
Series A Investor 174914.99%74912.23%1,12416.36%
Series A Investor 274914.99%74912.23%1,12416.36%
Series B Investor1,12418.36%1,12416.36%
ESOP50010.00%5008.17%5007.28%
Total3,000100.00%4,998100.00%6,122100.00%6,872100.00%

A small difference makes a big financial impact

Make sure you understand the type of anti-dilution protection in your investment agreements and how it can affect your stake in the company. Even a small percentage difference can translate into significant financial impact if the startup eventually sells for a large sum.

The bigger the difference between the pre-money valuation in the first investment’s round and a down round, the bigger the dilution impact.

Securing a high valuation in the early stages might be tempting, but it comes with the risk of a down round if the company doesn’t grow as expected. Be cautious and informed about these terms to avoid unwelcome surprises in your entrepreneurial journey.

For an in-depth analysis of anti-dilution protection, consider seeking expert advice or referring to resources such as Monard Law's "On Good Terms" for guidance.