Concerns with Equity Based Compensation – The Danger of Dilution

In our earlier blog, we said we’d explore three areas where startup companies can run into difficulties when dealing with stock compensation as part of executive compensation packages or to reward other stakeholders or vendors.

Call them Growing Pains or Mistakes We Wish We Hadn’t Made.  We’ll call this one The Danger of Dilution.

When we advise start-up companies, we often see founders or founding teams comprised of relatively young business people with great ideas, passion and drive but who have limited or little understanding of some basic business realities including what kind of corporate structure their new company has or should have, or will grow to adopt. For instance, is the startup incorporated as an LLC or is it an S or C corp? Does the corporate structure have different classes of stock and multiple subsidiaries?

The first problem to deal with is which entity should grant the stock compensation? Should it be the holding company LLC or the subsidiary S or C corp? Should it be common stock, preferred stock or member units? Should it be whole shares or units or options to buy those shares or units?  Those are a lot of questions and we’ll not tackle them all right now, but here are some considerations for entrepreneurs to take up with their professional advisors:

• Under what form of corporate governance does the start-up operate?
• Have or will stock options be granted to key employees? What percentage will remain under founder control?
• Is there an equity participant in the new company’s common stock (e.g., a PE fund or an angel investor) and what percentage of the stock has been granted as options to them? What percentage remains controlled by the founder?
• Is there a holding company with preferred stock; is there common stock; and, further, are there subsidiary companies with stock? 
• What is the effect of dilution when the next stage of investments occurs? When is the founder the victim of dilution and no longer in control of the company? 
• What are the steps that can be taken to mitigate dilution and have they been instituted?
  • Making grants on an annual basis to keep the ownership levels consistent. 
  • Awarding the founder a number of make-up or catch-up grants that restore ownership percentages.
  • Negotiating a floor agreement whereby a founder’s stock ownership percentage never falls below a certain level.
   

All of these issues should be considered in a timely manner before the company starts issuing grants or options. Failure to do so can lead to loss of founders up side ownership potential and control through dilution.