Angel Investing: Dilution Preventive Measures (Part 3)

This is Part 3 of our quest to answer a reader’s question on dilution.

The reader writes -

How do you prevent being washed out as you keep pro-rata and the numbers get increasingly bigger?

Suppose you invest $200k for 25%. The venture then raises $5m, so to keep pro rata you do $1.25m of that round. Then it raises $15m. Eventually it gets hard to follow you money and you get diluted down significantly.

We’ve covered dilution in an up round in Part 1 and examined dilution in a down round in Part 2. Here, we’ll go over some of measures you can take to lessen the impact and/or likelihood of getting burned by dilution. If this topic is new to you, you may want to read the basics in Part 1 and Part 2 before proceeding.

Note: Not all of the measures below can be taken simultaneously. Sometimes it’s either A or B, but not both. Talk with a lawyer who’s very experienced with startups and angel financing to gain a better understanding of the terms and deal structures.

Aligned Interest. Align your interests and objectives with the founders’. Paul Graham of Y Combinator writes:

Dilution is normal. What saves you from being mistreated in future rounds, usually, is that you’re in the same boat as the founders. They can’t dilute you without diluting themselves just as much. And they won’t dilute themselves unless they end up net ahead.

One way to do this is to offer entrepreneur-friendly terms, such as opting for common shares instead of preferred shares. The tradeoff is that common shares offer you very little protection.

Another way is to agree on an exit strategy early on. Basil Peters — an angel investor, prolific speaker, and author of Early Exits: Exit Strategies for Entrepreneurs and Angel Investors (But Maybe Not Venture Capitalists) — believes that “angels, and entrepreneurs, would have fewer dilution surprises if companies had good alignment on an exit strategy before the first investment went in.”

Angel-Only. Focus on angel-only deals to prevent follow-on financing from VCs (which can be very dilutive), notes Peters. The companies should require only US$0.5 million to US$3 million to prove its business model.

Early Exit. Big corps like Google are increasingly buying pre-revenue ventures as their growth strategy, says Peters. Help the company exit early (e.g. look for an attractive acquirer before it becomes sustainable or profitable) once it’s proven its business model. Exiting early allows you to cash out and helps avoid raising dilutive rounds.

Anti-Dilution Provision. Include anti-dilution provision in the term sheet, which allows you to re-price your stock if subsequent funding rounds are down rounds. In general, this comes in 2 forms, full ratchet and weighted average ratchet. More on anti-dilution protection in a future post.

Even if you’re protected by this provision, later investors can force you to waive or remove it. It’s really a matter of bargaining power. If the company needs the cash to survive, but potential investors refuse to invest if you don’t waive your right, then the company could die.

Board. “Negotiate for permanent board status or at least observer status,” advises Jeffrey Leavitt, partner of DLA Piper. This way, you can “learn of pending company activity that could affect [your] interests.”

But don’t take this as you-should-stick-your-nose-into-every-little-detail. Y Combinator, for example, interferes as little as possible. The seed firm realizes that independence is one of the reasons startups succeed. “Investors who try to control the companies they fund often end up destroying them.”

Though we should mention, the amount Y Combinator invests is relatively small — usually around US$11,000 + US$3,000 per founder. Which means US$17,000 for 2 founders, US$20,000 for 3, and etc.

Capital Efficient. Invest in companies that don’t need a lot of capital to reach breakeven or profitability. These companies have better odds to become self-sustainable; they’re less likely to be desperate for cash or funding from outside investors.

“[Capital efficient] means go-to-market (funding) is right around [US]$2 million, and maybe up to $4 million to get to cash-flow break-even and that’s got to be it,” stated James Geshwiler, managing director of Lexington’s CommonAngels and past chairman of the Angel Capital Association.

Deal Structure. Avoid unnecessary dilution by acquiring preferred shares or convertible debt, which converts to shares at a later date when the venture is properly valued by professional investors, Leavitt further suggests.

Follow-On. Reserve funds for follow-on investment. John Huston of Ohio Tech Angels Fund said, “The angels’ best protection against a ‘down round’ is to have adequate dry powder to preclude the need to seek new outside investors.”

Milestones. Before you invest, make sure the company has set, and will likely hit, milestones that will increase its valuation before raising the next round. Increasing valuation in the next round means there’ll be no down round. As mentioned in Part 2, down round can be very dilutive and can decrease the value of your holdings significantly.

One angel says, “[Significant milestones include] licensing of a critical piece of technology, completing a prototype, entering into an important partnership, entering beta testing, completion of FDA I testing, achieving first revenues, etc.”

Valuation. Value the company reasonably from the start. New angels frequently pay too much at the early stage, placing too high a value on the startup. Over valuation is more prone to down round if the company needs to raise more money from outside investors in order to get the business going. Again, down rounds can significantly dilute the value and size of your holdings.

Final Words

Dilution is inevitable in both good times and bad. When it comes down to it, you ought to be confident that the company’s valuation will exceed the impact of dilution before opening your checkbook; otherwise you may want to pass on the opportunity and look for one that has such potential.