My Big Rethink Part 6: When is it Time to Renegotiate Investor Preference and Anti-dilution in Order to Protect Employee Shareholders?

This is the sixth in a series of posts related to rethinking governance and compensation practices at venture-backed technology companies. My perspective is formed by 35+ years of running and investing in these types of projects where I have helped create wealth for investors, founders, and employees. Previously, I have written on the importance of protecting employee representation on boards, ensuring fairness around secondary stock sales by employees, revising how we handle employee option exercise policies, the importance of responsibly maintaining 409a valuations, and how to create more fair and transparent executive compensation.

This rethink is how we manage investor preferences and anti-dilution protections when a company’s valuation gets squeezed – particularly when employees are being asked to execute on new strategies that require their full commitment. This topic is even more relevant as we move into a new market reality where funding, acquisitions, and public IPO valuations will inevitably be depressed from where they were only 12 months ago. The subjects of investor preferences and anti-dilution are not typically understood by employees. But they can be critical factors in determining the value of employee equity compensation and need to be more openly discussed as technology startup boards construct incentive plans that will keep their teams focused and motivated.

Liquidation preference and anti-dilution are commonly part of deal terms for a new round of venture funding. They are downside protections for investors that serve an important purpose.? Venture-backed startups would not exist without venture capital. Venture capital would not exist (or at least not as much of it) if not for limited partners who invest their money in funds with an expected return. Preferences work by ensuring that investors get paid first in an acquisition before any money goes to common shareholders (including founders and employees). Anti-dilution works to maintain a prior investor’s ownership stake in a company when a new investment happens at a lower valuation.

Downside protection is important for the economic model of venture investing. It is not predatory, it is just investor economics. The challenge comes when the company value changes substantially such that preferences or anti-dilution impact the value of employee held shares and options so they no longer have the incentive value they are supposed to.?

By way of illustration, let’s say Acme Technologies raised $1B in investment over several rounds of financing, with the latest post-money valuation being $2B.? For a variety of external and internal factors, Acme’s enterprise valuation falls dramatically to $500MM. The company tries to right the ship by streamlining operations and introducing a fresh management team.? But while the liquidation preferences have remained $1B, the enterprise value of Acme is now well below that amount.?

The problem for Acme is that employees are given equity in the company through interests (like options) in common stock. Common stock sits behind the preferred stock in rights to cash distribution in an exit.? And under the changed circumstances, even doubling the value of Acme would not yield any returns to holders of common stock.

So what if the company’s strategic plan is to find a buyer or raise more capital in the next 12 months? Let’s look at these two scenarios.

Acme Sells. Hooray...I think?

Employees are excited that the company has made the correct changes and motivated to support the strategy and get the company ready for a sale. The company enters into an agreement to be acquired for $1B! The preferred investors would take all of that $1B under the terms of their investment. Common shareholders get $0, BOO!

Is this fair? Well, yes and no. It is fair that investors can negotiate downside protections that help them protect their limited partners’ money.? But it is not fair that employees were working hard under the assumption there would be a payout if their strategic plan succeeded.? It is not fair for boards and investors to ignore the fact that employees probably don’t understand venture economics enough to realize they don’t have any economic incentive to stick it out.? And it is particularly unfair if the board – including investor representatives – bear some of the blame for the mismanagement that put them in this predicament.

The right thing to do is for investors to make changes to their preference terms to ensure that employees will be fairly compensated if they execute on their new strategic plan. There are different mechanisms for doing this, but in principle, employee shareholders should get to share in proceeds from a sale regardless of the valuation. It is not a huge outcome for anyone, but it is fair with risk (and reward) properly distributed.

Acme Raises Money in a Down Round. Now What?

Acme management and the board decide to retrench and try to rebuild their momentum. In order to shore up their balance sheet, they decide to raise money. The company raises $200M from venture investors at a $500MM valuation. Investors have anti-dilution clauses in their contracts that protect their percent ownership in the company. This means the holders of some of the existing series of preferred stock may increase their percentage ownership automatically without any further action.? This dilution further erodes the value of common stock.

Is this fair? Well, yes and no. Anti-dilution is important for new investors trying to protect their interests.? But if the new investment is severely damaging to the incentives of employees, it is important to be transparent and to create new incentives that will support recruitment and retention. It is certainly unfair if investors that were complicit in the poor decision making that led to the down round receive a benefit not provided to employees.?

The right thing in this case is for holders of preferred stock to waive any anti-dilution protection that would otherwise be triggered by the down round financing, so that everyone shares equally in the dilution of the new money.

Bottom line

There are many reasons companies may find themselves in this position.? It could be the market. It could be bad luck. It could be mismanagement. It matters if boards and investors contributed to the mismanagement or poor strategy that led to the situation.? If they were part of the problem, it is fair for them to share in the pain.?

More importantly, employees need to be treated with fairness and respect. Hoping they remain ignorant of the value of their equity incentives is a terrible strategy. Ensuring that employees have incentives to execute through difficult times is a good strategy. It is completely unfair for boards – dominated by investors – to push all the economic pain of a down cycle to the employees.

Employees need to ask questions and speak up. Management and independent directors need to lead the negotiation with investors to protect the interests of employees.? Investors need to think strategically about the long term costs of hanging on to anti-dilution and downside protection provisions when they limit the value of employee incentives and create misalignment between parties that should be partners.

As always, I am happy for your thoughts.