Should Early Employees Get Anti-Dilution Rights?

No. Founders and early employees should really never receive anti-dilution promises as part of their initial grants. Instead, the company should figure out the correct number of shares to grant the employee from the start.

Employee Anti-dilution Rights Are Unnecessary

If the startup issues shares to new investors in a financing, the employee’s existing shares will be worth more. The shares will represent a smaller percentage of the company, but the financing makes the company more valuable overall.¹ Scroll through Venture Dealr for a cool visual explanation. The employee’s equity percentage doesn’t have to remain the same for the employee to reap the benefits of the financing. Each share that she owns after the financing will be worth significantly more as a result of the new investment. Employees benefit from a financing even without anti-dilution rights.

If a startup grants anti-dilution rights to an employee, it will run into problems when future investors find out. Investors will likely refuse to invest unless the employee’s anti-dilution guarantee is removed. At that point, the employee holds significant leverage over the term sheet negotiation.

Employee Anti-dilution Rights Are Problematic

They adds unnecessary complication, especially to financings. They tend to deter investors, and may give the employee undue influence over a financing. If an employee demands anti-dilution rights, there is a good chance that they don’t understand the mechanics of issuing stock in a financing. Walking them through the benefits may change their mind and help you make the hire.

One simple example: Let’s say a company is worth $20M and raises $10M by selling 1/3 of the company. Pre-financing the 1% owner owns 1% of a $20M company, or $200K worth of equity. Post-financing, the owner owns 0.667% of $30M company (the company is worth $10M with an additional $10M in the bank), also $200K worth of equity. It wouldn’t make sense to keep the person at 1% and arbitrarily increase the value of that equity from $200K to $300K just because the company raised financing.

In Rare Cases, Employee Anti-Dilution May Make Sense

One situation where it may make sense to grant anti-dilution protection to an employee is when a board brings in an outside CEO close to a financing round, and is expecting the CEO to facilitate that financing round soon after he joins. But even in those cases, most boards should instead grant the CEO an appropriate grant with the expectation that the next financing round would occur shortly after, and the CEO would be diluted along with everyone else.

Investor Anti-Dilution

Investors may demand anti-dilution rights to protect against a down round. (e.g., they mistakenly overvalued the company in a Series A, and when they discover this in the Series B, they want to get some extra shares to make up for their initial overpayment). Investor anti-dilution rights only kick in during a down-round, not a normal financing.

Links

Delusions About Dilution. Kenneth Obel, 2014.