Ask HN: What assurance do early startup employees have against dilution?
I'm considering joining an early-stage startup, with substantial equity compensation.
I'm wondering about the industry norms, not looking for any answers specific to my case - I know I should read everything myself and contract a lawyer if in doubt when it comes to that. Still, hoping for some helpful background knowledge from HN about how these things typically work.
What happens, if, say, the startup is successful, and your equity has worth in the millions of dollars at the startups last valuation, but after your four year vest is up and you leave, the founders and board decide to issue new shares to themselves and all investors to dilute the value of your shares down to nothing? Seen in strictly financial terms, it seems to me that it would be in their interest to do so, aside from the hit to their reputation. And being no longer employed by the company, it seems to me that you wouldn't have any leverage to prevent this by threatening to leave.
My best guess is that the situation works something like this: As a Key Shareholder (>1%), you have to approve the issuance of new shares. However they can get around this, maybe by taking you to court for breach of contract, or by invoking some clause that otherwise allows them to bypass your right to be consulted to approve the issuance of new shares.
How does this typically work? Is it something that varies significantly by startup? Is it the industry norm that early startup employees are dependent on the goodwill of the founders and board even after their equity has vested?
30 comments
[ 3.0 ms ] story [ 74.8 ms ] threadEveryone is diluted during a financing round.
Long answer: some early or critically important employees will receive grants after a round to offset some of the dilution.
I’ve never heard of this happening successfully. What you’re probably asking is “how can they screw me?” And the answer is if they terminate you before youre vested. That’s why as an early employee you want to negotiate some type of accelerated vesting schedule.
Technically the existing shareholders are asked to agree to the changes as a condition of the new investor(s) putting money in. Sometimes they are given the right to put in money to keep a real position in the newly-recapitalized company.
My advice: don't over value your equity compensation.
Or stuff like the founder's kid gets a large new equity grant for joining to create the company esports team (in a company with nothing to do with esports).
"Key shareholder" isn't a thing. Shareholders elect/appoint board members. The board issues new shares. A shareholder with simply >1% of equity, say 2%, has no power over the board.
You, as an employee, have no guarantees against dilution. Dilution isn't necessarily a bad thing IF the overall value of your equity increases (e.g., the company raises at a larger valuation).
The odds of the board deciding to screw over one employee with a small share of equity seem quite low. The potential legal costs and reputation risks will most likely outweigh the cost of either buying you out or, what is most likely, doing nothing.
Also note early investors often have a liquidation preference meaning they get their money out before subsequent investors but this also isn't something which is usually extended to employees.
You will get diluted beyond all belief. Not just by investors but by future grants to employees. The best that you can hope for is that that dilution corresponds to growth in the equity of the company such that you own a smaller share of a larger pie and in overall dollar value your stake becomes more valuable or at least maintains its value. It's worth mentioning that in the vast majority of startups this does not end up being the case and equity ends up not being that valuable. There is a very small probability of a lifechanging exit though which is why people go for it.
Larry and Sergey owned 100% of $0 and like, 20% of $1 trillion. Which would you rather have?
For example, if a new employee comes on board and gets a grant everyone else gets diluted a bit. This is a good deal if the new employee will generate sufficient value to offset this dilution. I think we can all come up with examples where this would or would not be the case.
Likewise with investors. Sometimes a new round will be exactly what a company needs to light the touchpaper and everyone will see a huge benefit in spite of dilution. Sometimes it’s just more cash on the big bonfire and not only does it not fix the fundamental problem but also hurts all the existing holders to add insult to injury.
FWIW, what you described isn't right of first refusal. ROFR specifically refers to the right of an existing investor to buy shares when another investor wants to sell to a third party. E.g., let's say A has a right of first refusal, and B wants to sell at $20 / share to C. With ROFR, B must offer $20 / share offer to A first.
The right to buy shares proportional to existing ownership percentage is called a pro rata right. If a round of funding would dilute your 1%, you have the right to buy in at the pricing of that round to keep your percentage ownership constant.
"Control shareholders have a fiduciary duty to the minority shareholders to act with 'good faith and inherent fairness.' As such, majority owners have a fiduciary responsibility not to use their influence to engage in self-dealing, including actions that are unfairly prejudicial to the minority shareholders."
See: https://ffslaw.com/articles/have-the-controlling-shareholder....
If everyone gets diluted for new funding that's one thing and you have no protection against that. But if the 51% just vote to fuck over the 49% that's very different.
You WILL be diluted during every fundraising round and you will be subject to lockout periods. You may exercise your shares if you leave early but you take enormously doing that.
Then things might work out, but the nature of startups is they probably won’t.
Good luck.
I've yet to see any startup do this though, which to me indicates that the intent is to scam the IC.
The last time I got some, not much, 75% of the profit was from post IPO: so could have achieved the same thing by working as a contractor elsewhere for more, then buying at IPO :-) “But your a shareholder now you should put more effort in” they’ll say lol
Equity compensation is essentially a legalized SV scam.
If you're an employee #6+ and not an insider - just negotiate a salary figure and/or work conditions.
Even if your shitty startup gets money laundered (I mean acquired) for 12 figures you are getting exactly zero of these figures.
That's a plan.
And startup lawyers smiling you into signing "just a standard" contract are getting paid big figures to laugh you out of the door after exit transaction.
Remember that ALL early investors are diluted when new money comes in. For example the first Angel investor may opt to add more money to new investment rounds to buy anti-dilution shares. Think of your continued contributions as adding more value in return for anti-dilution shares.
That said, getting rich from options is a fool's bet. Take a good salary then save and invest it. You'll be better off and the risk is much lower. You are far too close to the situation right now to judge the likelihood of success for your startup and have no idea how many factors hidden to you will make or break that bet. FTX, Theranos, ...
The reason VCs can play this game is that they have certain advantages and they place 100 bets to one success. You can place only one in that same timeframe. Even they would not play that game.
Generally speaking, in terms of risk early employee has an unfair advantage over investors (though investors have other ways to mitigate that risk, like liquidation preference).
In short, the startup lottery is just a fiction now, perpetuated by VCs to create an endless treadmill of labor.