On Anti-Dilution Policies

Written by Ian Sharp on June 17th, 2019


Ian Sharp here and you are listening to The Good Doctor on Motion Reboot.com

We're going to cover a great topic today, anti-dilution policies. They've been popularized by movies like the social network, the told facebook story.

Anti-dilution

What is anti-dilution? It is the idea that no matter what happens to the company in the future, that you get to own the same percent of the pie. As continued paid or unpaid effort go into building the company, and further rounds of financing pour in, the percentage ownership you have in the company remains the same. Regardless of whether or not you invested additional money or put in additional work yourself over the years. It sounds great to some. A free ticket to lethargy and great returns. In theory, for the person who has anti-dilution, you put in little effort early on and reap massive rewards later on as a company grows (or doesn't grow). In the long run for the company as a whole, and the people trying to move the business forward, it's lethal. They all know your anti-dilution is "not fair", and you successfully disincentivizes anyone who can see that. As the company develops, the amount of work effort each contributor puts in goes up, while their reward goes down. Their reward goes to the person who came first with the anti-dilution policy. So, it's easy to see how anti-dilution policies can stifle growth long term.

There are those, that believe they are entitled to anti-dilution. It can be a trust issue, or the belief that they are just being practical. Though, one chief reason claimed for anti-dilution goes like this, "Well, I took all the risk by investing early on. Later investors have less risk. And I want to make sure no one can take away what I earned." The rest of this article explains why that's a false claim. It's as false for investors as it is for product operators, as it is false for sales folks. I will go over each in detail. We are going to talk about opportunity cost now, versus opportunity cost in the future and risk.

Let's look at the creator, the operator, the engineer (whatever you want to call it) and their opportunity cost in terms of time. Wages foregone by using their craft to build a company early on versus later on is the same. If your time is worth $100 an hour today, then likely your time will be comparable next year. It's possibile that if you get better at selling yourself and learning technology over the cours of a year that your time might increase to $125 an hour. On the other hand, if you don't keep changes with technology, and allow yourself to be sold short, your rate could decrease to $75 an hour. So the opportunity cost, which is giving your time to build a company early on, compared to 12 months in the future is likely pretty much the same. Most of the risk is within your control and depends on how motivated you are in technology, combined with market opportunity. So is anti-dilution justified on the basis of opportunity cost here? No. The risk of foregone income is the same now as it is one year form now. As such, it does not make sense for product creators to claim, "I took all the risk early on. I deserve anti-dilution later on when there is less risk."

Now the investor. The opportunity cost an investor has by using their money to invest in an early stage, versus a later stage company is also the same. If you're good at investing, the amount of income you generate now, would be similar in 12 months. Your income could go up or down, just like an engineer. Your income also depends on your motivation to your investing craft, combined with market opportunity. Now, putting your $1 into startup A, might preclude you from putting $1 into startup B. If company B exists, and company B is perceived to be a better investment, then company B would be the clear choice to invest your money in. So there would be no opportunity cost, you just invest in the best company. If company B does not exist, then certainly you have no opportunity cost from the perspective of investing in a winner versus a loser. For investors, most of the risk is within your control. Risk is a function of how motivated you are at understanding how to investment wisely, mixed with market opportunity. As such, does it make sense for the investor to claim, "I took all the risk early on. I deserve anti-dilution?" No. It does not make sense.

Now the sales folks. Wages foregone by using their craft to get further investment in the startup or to make sales at a company early on versus later on is also the same. If your time is worth $1000 an hour today, then likely your time will be comparable next year. For most people in sales who are doing well, their network is supposed to grow and their ability to perform in the next year would increase. Most of the risk is within your control and depends on how motivated you are in sales, combined with market opportunity. So is anti-dilution justified on the basis of opportunity cost here? No. The risk of foregone income is the same now as it is one year form now. As such, it does not make sense for sales to claim, "I took all the risk early on. I deserve anti-dilution later on when there is less risk."

I'll close by asking a question that could've summarized this article at the beginning. "Are mid-stage startups more likely to succeed than early stage?" The data I've seen suggests that percentage-wise, the likeihood of achieving the next round of funding actually GOES DOWN at each stage. Meaning the earliest-stage investment actually has THE MOST LIKELIHOOD of succeeding (meaning the least amount of risk). So does it make sense for an anti-dilution clause in an early stage startup, because "I am taking on all the risk at an early stage, therefore I deserve to not be diluted later.". No. Definitley No. For the last time No. You might "want" to not be diluted later, but starting early and "bearing the most risk" does no come into the equation.

An interesting take-away I get from reading my own article is that risk is a function of YOU and whether you plan on improving or not. In other words risk is not completely external. Risk is also in you, and a function of your decision to improve yourself. Therefore, it follows: if you decide to be more valuable next year, your risk in an early stage startup today is always going to be lower than risk in an early stage startup tomorrow. If you deliberatlye decide for yourself to be less valuable next year, then that is another story, and your risk for participating in an early stage startup now is certainly higher than your risk next year.

Given all this, I say to you, beware the dude who requests anti-dilution. It may be that they have decided, if even their subconscious, to be less valuable next year than they are this year, and they want to get paid for it too.

** what about other metrics beside opportunity cost ? ** email questions to ian@motionreboot.com **what about over a longer period of time - 12 months in the future ? ** email questions to ian@motionreboot.com

Ian Sharp PhD

Ian Sharp helps setup businesses to succeed by advising on the best corporate policies to place. If you're thinking about starting a technology company soon, or already have and you're wondering if it's too late to restructure your company policies, then definitely reach out and request your free case study today.

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