Help! I'm seeing companies add provisions that dilute shareholders if they don't participate in future fundraising rounds. Is this a red flag?
Maynard Webb
Founder, Webb Investment Network; Author ‘Dear Founder’; Board member Visa and Salesforce.
What are your thoughts about founders requiring current preferred shareholders to participate in future funding rounds through provisions that severely dilute non-participants? I've had a few companies I've invested in do this. Is it something founders should use as a tool in fundraising?
-Angel Investor
Dear Angel Investor,
Let me be direct: this is not an ideal situation.
These provisions typically originate from investors, not founders. They’re designed to ensure broader participation in financing rounds, preventing some investors from getting a "free ride" while others carry the full burden. But this circumstance raises several red flags and calls for scrutiny.
This scenario generally doesn’t happen to fantastic businesses that are going gangbusters. We often see it in struggling ones where investors are seeking to protect their positions and trying to get a pound of flesh from the company and other investors. It might also signal that the long-term prospects of the company are suspect.
In optimal circumstances, a company’s performance allows it to raise capital on terms that treat all stakeholders fairly. When companies resort to preferential treatment structures, it often signals limited options for the company.
As an investor and preferred shareholder, your original investment comes with certain rights. While these typically remain through subsequent rounds, challenging business conditions can change this dynamic. New investors might impose stringent terms requiring existing investors to either participate in their pro rata or face conversion to common shares at onerous rates, which effectively diminish both the quantity and value of your shares.
This leaves you playing defense where you must weigh two options:
Invest more at the current terms
Accept devaluation of your original investment
Your decision should be based on your assessment of the company’s future prospects. If you see genuine potential, maintaining your position might be worth the additional investment. If not, it may be better to accept the pain now rather than compound it.
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3wAnother aspect to consider is the impact on the company's culture and long-term relationships with investors. For instance, in the AI industry, some companies have successfully raised funds by maintaining transparent communication and aligning investor interests with company goals. This approach can foster trust and encourage ongoing support, even in challenging times. How do you think founders can balance protecting early investors while attracting new ones in such scenarios?
Self employed
3wJust always remember that tomorrow isn’t promised. You can choose a little now or take the risk and potentially lose a lot more in the future. Assess performances and how the companies overall fluctuations within the last 2 to 3 years then determine what’s the best fit for your future financial goals.