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Intro to Private Equity-Venture Investors Equity Dilution Issues (Part One)

When a private equity, venture capital or other venture investor firm is considering an investment in a target company, the venture firm will consider whether a one time capital infusion will be sufficient for the venture firm to achieve its return on investment goals. For example, a target company may only require a one-time investment in order to grow to the next level, or the investor may be able to purchase control of the target with a single purchase price payment.

However, private equity groups and other sophisticated investors often invest in companies which require several rounds of financing in order to reach their desired rate of return before being able to exit. Sometimes in spite of the investment, the target company becomes troubled and more financing must be injected so that it can continue operating.

Whenever additional funding is invested in a company, prior investors (except in a debt offering) see their percentage of ownership reduced or diluted because the company issues additional equity. This equity is then distributed to new investors in exchange for their financing. Sometimes, the new investors receive actual equity and sometimes they are given securities which convert into equity (or both). Regardless of the form, the issuance of additional equity automatically reduces the percentage of equity owned by previous funders. The potential dilution of previous funders can be particularly pronounced when a “down” financing round is required. A down financing means a funding where the current per share valuation is less than it was at an earlier buy-in. In a down round, the new investors receive an even greater share of the target’s equity, because if the per share value has been diminished, each dollar invested purchases more equity than was previously the case.

The need for additional capital investments creates a delicate dance between the (1) founders of the company, who do not want to be overly diluted, but understand the need for more than one round of funding necessary for company growth or survival; (2) the first round investors, along with subsequent investors, who also do not want to be overly diluted, and who wish to protect their investments, but also understand they must give up something in exchange for funding from new investors; and (3) the investors considering financing the current round of funding who have every reason to drive a really tough bargain.

Early stage investors usually build provisions into their investment agreements in order to ameliorate the dilutive effects of later rounds of funding. They understand that if they are too insulated, their protections may have the unintended consequence of becoming a substantial impediment against future investors injecting capital into the enterprise.

Anti-dilution protections (and the compromises usually reached by all parties) come in many varieties, but generally fall into three categories: (1) preemptive rights, which allow existing equity holders to purchase additional equity, and thus maintain, to a lesser or greater degree, their equity percentages; (2) explicit conditions and/or limitations of allowable dilution; and (3) more or less favorable conversion privileges. These privileges allow earlier investors to partially or entirely “catch up” to the value of equity held by later stage investors when an exit or liquidity event occurs, by converting the value of their “old” equity or convertible securities to equity having a more favorable valuation.

Many entrepreneurs and key employees receiving incentive compensation in the form of straight or convertible equity, have only a minimal understanding that their equity positions can be severely reduced as future rounds of financing occur. They often have even less understanding of the techniques commonly employed to limit or allow a certain amount of dilution. As indicated above, different parties have conflicting interests in allowing more or less dilution to occur. Professional investors, by contrast, have a keen sense of the importance of this issue.

In addition to the considerations discussed above, this article generally introduces pro and anti-dilution techniques. These techniques will be discussed in detail in the next Client Alert in this series.

If you have any questions about the techniques discussed in this client alert, feel free to contact your Davis & Kuelthau corporate attorney.