Founders Face Dilution in Follow-on Financings –

WASHINGTON – Just a few years ago, owning founder’s equity in a successful venture-backed company was akin to holding a winning lottery ticket. Both seemed to guarantee riches beyond anyone’s wildest imagination.

But now as many venture-backed companies are struggling to hold on in the wake of down rounds and a dormant initial public offering market, the Darwinian law of the capital table is squeezing out founders, according to Bob Gold, president and chief executive officer of Ridgewood Capital. The majority of founders are seeing their ownership stakes diluted to almost zero because of successive financings, Gold said. “The only thing that matters now is new money and existing critical employees. No one gets rewarded for what they put in a year ago,” he said.

If that’s the case, then founders appear to be in for an even rockier future. The National Venture Capital Association in early September released a statement noting that in the next 12 to 18 months a large percentage of the $45 billion overhang of venture capital (funds raised and not yet invested) existing at the end of the second quarter would likely go to existing portfolio companies.

While not everyone in the VC community thinks this issue is affecting as many founders as Gold does, the question of dilution is a delicate one for VC firms since it will affect the way the entrepreneurial community views a particular group, noted Dana Callow, a managing general partner at Boston Millennia Partners. “You always worry about the founders, because it is your reputation as a firm that is on the line, so it is a small price to pay to treat founders fairly,” he said.

Dilution really raises the question of who’s a critical employee at a company, Callow said. “If a founder has hired other key employees and augmented the management team, then they have done a good job and maybe they are not really a critical person anymore,” he said. “If they are important then we may keep them whole in subsequent financing.”

In a recent round of financing for one of its portfolio companies, Boston Millennia and its co-investors took the dilution because the company’s existing management team was really adding value, he noted. “We felt we owned more than enough of the company to be successful and that it was really important to deal with people assets well.”

The key in a difficult situation is to work with a founding team to make sure that everyone understands the parameters of the financing situation, said Bill Elmore, a general partner at Foundation Capital. “Everybody is impacted by the fact that for several years companies raised too much money and spent it before they proved their model,” he said. “In my opinion, at solid companies that are prudently financed with healthy block of stock, the founders should be okay.”

VC firms want to keep management teams incented and reward producers, so, like Boston Millennia, boards will often be willing to incur dilution, rather to keep key management employees happy, added George Bischof, a general partner at Focus Ventures.

The one way for a founder to ensure that he will profit from his association with a company then is to make certain he becomes one of the critical employees at the company going forward, Ridgewood’s Gold said. This means the founder ultimately will have a meaningful equity stake in the company as an integral part of its management team, not simply for founding the company, he added. “So the conversation you have with a founder then is about why they should feel good to be a critical part of the company’s future success,” he said.

The issue of dilution and how to properly treat founders may also be a matter of perspective, noted Focus’ Bischof. “Entrepreneurs thinking they can own 40% to 50% of a company are as out of bounds as VCs thinking they can generate a 10 times return today,” he said. “People may feel squeezed in terms of what ownership levels were the last few years,” he said, adding “but in the 1980s and early 1990s, entrepreneurs owned 15% to 20% of their companies, while VCs generated three to five times returns-so the reality is everybody still has a good opportunity to be very successful.”

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