Occasionally, however, an important potential or existing manager of an emerging company may ask that his or her percentage ownership of stock options be protected against percentage dilution. I am spurred to write this note because I have run across the situation several times recently.
As an example, you might hear something like this from the potential or existing manager: “I know there are going to be at least a couple of rounds of equity financing in the future that will dilute my current share ownership. I need to be assured that my percentage ownership won’t fall below a certain level.” Were this point of view not contrary to traditional venture capital financing theory, it might sound like a reasonable concern from the standpoint of an individual manager, but it almost never makes sense.
Here’s the bottom line: as a general rule, in a high-growth company relying on one or more rounds of future financing, a manager should not be protected from percentage dilution.
Here’s why:
Percentage dilution naturally occurs as a company issues more stock or stock options, on a fully diluted basis (meaning the capitalization of the company, including shares issued and all rights to convert into shares issued and stock options). Dilution of stockholders’ ownership percentages occurs without fail as more common or preferred shares are issued except: (i) to the extent a preferred stock investor has anti-dilution rights to counter a down round as described above, or (ii) if, as stated above, the preferred stock investor has been granted and exercises pre-emptive rights to buy new shares to avoid percentage dilution. Managers, merely by virtue of their positions as common stock option holders alone, are not granted these anti-dilution rights as a matter of course.
It makes even less sense to grant managers who own stock options protection against percentage dilution. They receive common stock options as sweat equity and the value of the options should increase with increases in the value of the company. Management should do everything it can to cause the company’s value to rise, measured by an increase in the price per share, not by percentage ownership. And if the value decreases per share, management’s sweat equity should decline in value. This is true because sophisticated investors want to reward, and be rewarded by, management’s performance. Protecting management against percentage dilution runs up against this basic principle because, upon the issuance of new shares diluting every other stockholder (including preferred investors, if any), such protection against percentage dilution creates a benefit for the manager that has nothing to do with management performance and which – to gain the same benefit – other preferred investors with pre-emptive rights would have to pay for.
In addition, giving percentage anti-dilution rights to certain management employees and not others may be destructive of team building. When a company issues new shares to raise money, the manager who has percentage anti-dilution protection would be issued new shares to protect against percentage dilution, which would further dilute fellow managers who do not have the same protection. Rather, managers should play by the same rules even though their equity percentages may start at different levels.
For the reasons cited above, potential sophisticated investors in preferred stock see a manager’s anti-dilution protection of any type as a red flag. The CEO is like a ship’s captain who, with a crew of managers, is expected to protect the ship’s passengers – in this case the company’s preferred stock investors – first, foremost and always. Never should a member of the management receive preferential treatment, or protection from dilution, over or on the same level as a preferred stock investor, except to the extent such a manager actually invests his or her own money in the preferred stock itself (which comes with its own set of complexities).
A traditional way to address the natural dilution of the option pool over time resulting from the issuance of new shares is to increase the allocation to certain employees or refresh the pool by adding new option shares, based upon having met, or meeting in the future, performance goals that are important to the company as a whole. Refreshing the pool will increase the number of fully diluted shares outstanding. As in life, however, there are no guarantees, and this refresh of the option pool should be based upon needs and goals of the company as a whole at the time, as approved by the CEO and the board of directors.
