Emerging Enterprise Center Blog - Commentary and Analysis For Entrepreneurs and Startups

Antidilution has been the topic of a prior post and is kind of a tough topic.  I find I have to go over the concepts carefully with entrepreneurs. Some entrepreneurs tend to think of dilution as purely a matter of percentage ownership. Although ownership dilution is important particularly as it relates to voting control, investors are typically more concerned with financial dilution. Financial and ownership dilution are related but different concepts. Ownership dilution is easy to explain, if Easy Company has 1,000,000 shares issued and outstanding in the hands of stockholders, and you own 500,000 of these, you own 50% of Easy Company. If Easy Company then sells another 1,000,000 shares to a new investor, there will be 2,000,000 shares outstanding and you will still own 500,000, but now you only own 25% of the company. That is ownership dilution. 

Financial dilution is a little more complicated to explain. Using the same example, if Easy Company had 1,000,000 shares outstanding and sold 500,000 to you for $1.00, you would own half of the company and your shares would be worth $1.00 each or $500,000.  If time passes and Easy Company raises an additional $1,000,000 at $2.00 per share it would issue 500,000 new shares to new investors. As a result, there would be 1,500,000 shares outstanding of which you would own 500,000 or one third. So, you would have ownership dilution (you went from one half to one third). However, the company would have a valuation of $3,000,000 ($2.00 multiplied by the number of shares outstanding after the new financing). The value of your shares would have increased – not been diluted.

Suppose, however, that Easy Company raised $1,000,000 by selling shares at $.50 per share. It would then issue 2,000,000 new shares to new investors and the total number of outstanding shares would go from 1,000,000 to 3,000,000. The value of the company would be $1,500,000, and the value of each share would be $.50. In this example, your 500,000 shares now represents approximately 16.67% of the company (down from 50%) so you have suffered ownership dilution, and your shares are now worth $.50 each (down from $1.00) so you have suffered financial dilution.

The antidilution formulas that are a customary part of venture investments, are aimed at protecting the investor from financial dilution. How the typical formula works will be the topic of another blog entry, but for a very detailed analysis, see my article on the subject of antidilution.

I spend a lot of time with entrepreneurs explaining how restricted stock and Section 83(b) or the tax code work. It was the subject of a prior blog entry. However, it comes up so often and different people absorb the concept in different ways, so I thought it might be worth attacking again in a different way. Restricted stock can have some very material tax benefits when compared with options, especially in the early stages of any venture. So, here is how restricted stock works. I will compare it to options later.

You may want to incent employees by giving them stock. Here is an example. Easy Company decides to incentivize one of its employees by giving her a stake in the company. It then grants to Jane 100,000 shares (assume for the purposes of this example that the shares have a fair market value of $.01 per share). Two things follow. First, Jane owns the stock and, in our example, has no particular incentive to stay of the sort associated with vesting. Second, Jane has income equal to the value of the shares of stock she has been given. In this example she has income of $1,000. Easy Company must report (and withhold taxes for) this income on Jane’s Form W-2  for the year in which she was given the stock, and Jane must pay tax on that income. Now, $1,000 of income does not seem like much, but if the stock had a fair market value of $1.00 per share, Jane would have $100,000 of income on which she would owe tax. If her marginal tax rate is 40%, then she has to pay $40,000 of tax to the feds.

Continue Reading

In a recent board meeting for a client, one VC director described the current investment climate as follows:  "flat is the new up 50%."  Assuming he is right, and I think he probably is, several things follow.  Some of them are obvious.  Valuations are down; it is harder to get money than it was just a few months ago etc.

However, here is another prediction (perhaps it is obvious as well).  Certain deal terms that we have not seen since 2001 will start cropping up like mushrooms after rain.  Look out for full-ratchet antidilution provisions and multiple X preferences.  Also, you may want to review a section of your preferred stock that you may not have paid much attention to -- your antidilution provisions -- because they will be triggered by a down round.

I spoke with Peter Alcock, a long standing client and friend, the other day about the issue that keeps coming up with respect to personal liability, personal guarantees and the like. Peter is particularly well situated to address these issues because in past lives he has had to deal with these issues both as a consultant and as an entrepreneur. Fortunately, in his current life as CEO and owner of Beckwood Services, he doesn’t have to worry about these types of issues. Anyway, I asked Peter if he had only a few pieces of advice to give to an entrepreneur who found himself or herself defaulting on debt or leases, what would that advice be. Here, reduced to some bullet points is what he said:

•  There is hope. In the current climate, lenders and landlords are dealing with many problem situations, and they are likely to be realistic. It is never a good time to have a problem, but there will never be a better time than now because the economic climate looks bad for lenders and landlords too. They can only do so much with massive problem defaults. As a result they are likely to be willing to work with you. 

•  Be wary of changes in loan officers. If your bank suddenly changes loan officers, you may be in an undeclared workout.  Prepare for aggressive treatment from your lender.  No more Mr. nice guy here!

•  Keep your cool. As a general proposition, it will not help to become emotional and/or confrontational. 

•  Deal wisely with your cash. If you are in this situation, cash is short. It costs money to go through a foreclosure or a bankruptcy. You are likely to end up paying attorneys and others upfront. Conserve cash whenever possible.

•  Don’t fool with the IRS or state tax collectors. There are certain obligations such as withholding, sales tax, payroll etc. that must be paid or dire consequences could follow. Do not let the bank short you on A/R advances for these expenses.  Threaten to quit if necessary.

•  Consider your lender’s offset rights. Your lender can grab the cash in your account.  If your lender does this, it will leave you without the ability to pay payroll, withholding tax, etc. Such an action could expose you and your fellow officers and directors to difficult financial liability.

•  Think differently. If you know you are going to lose your business, change your focus to mitigating that issue alone.  Come up with a plan so that your creditors get the best outcome they can – you may run across the same lenders, suppliers, investors etc. in some future venture.

• Review your situation with somebody knowledgeable. Your personal situation needs to be reviewed by someone who is familiar with small business lending, leases, personal guarantees, investor documents, and your obligations under all the laws that might apply to you.

Anyway, this is what Peter said, and it is all good advice. Remember, while it feels like a 2000 redo, entrepreneurs found their way through that bust and this one will be no different.