Over-dilution? Not a problem!

Tom Wesseldine - Partner at Verb Ventures
The first half of 2023 has proven to be a turbulent time for the European tech industry, and the UK has not been immune to the challenges.

Atomico’s the State of European Tech’s First Look 2023 report, outlines the troubles the industry as a whole has faced: Total investment volumes in Europe are set to reach around $50 billion for 2023, representing a 50% drop compared to the record highs of 2021 and around 38% down on 2022. Amongst the data, The UK has seen a particularly steep decline, with a 57% fall in tech investment levels.

This adjusted market reality is here to stay, and the downturn is reflected by fewer new tech startups being created; about 15–20% fewer companies have been created year-on-year.

The funding landscape remains muted, and valuation multiples have stayed resolutely low (especially in later stage deals). In Q1 alone, there were 185,000 redundancies globally within the tech industry, with 6% of them in Europe. Furthermore, 1 in 5 venture fundraises in Q1 this year were down rounds, a 3.6x uptick compared to barely 1 in 20 a year ago.
What effect does this have on the capital structure of companies?

Well, from the data we’re observing, the major hit was taken by later stage (series b) with other stages not hugely affected by turbulence (this make sense considering the investment cycle from past couple of years).

But even so, this data is not entirely complete and we presume that at this time we can see on some occasions founders are being diluted quite significantly (more than is typical) to 15–20% ownership prior to their series b; as they had to choose between a bad (over dilution) or a very bad option (closing down).
What options do you have as a founder if you have been overdiluted?

Where the original shareholders’ ownership percentage decreases significantly, this can have serious implications for decision-making, motivation and the overall direction of the company. In this challenging environment, it’s crucial not to forget — the founder is the centre of any start-up and motivation should be at all times very much aligned with long term growth plans.

Thanks to common law flexibility there are a number of very good options on how to fix over dilution and bring motivation back to even the most diluted founder. Below are a few of the numerous options for founders to; incentivize themselves and key employees, align interests with investors and manage ownership structures.

The easiest of all is the EMI stock plan, which is tax advantageous and very popular, but we will have a look at options where, for whatever reason, this route is off the table.

Flowering Shares

Flowering shares are a type of share that starts with limited rights and then “flowers” into full-fledged shares with voting rights and other privileges once certain conditions are met.

For example, a founder might receive flowering shares that entitle them to a percentage of the company’s value above a certain threshold. If, at exit, the company’s value grows beyond that threshold, the founder would benefit from the additional value received as if they’ve owned the shares. Terms are not that complicated and only the event of an exit may be sufficient.

If the value does not exceed the threshold / there is no exit event, the flowering shares would have no value and will not create any pressure on the cap table and investor ownership.

This instrument fully aligns the interest of investors and founders who know that they can increase the value of the company over time — even though at first they took a hit on their position to save the situation.

Specification: Incentives long-term growth targets (ie exit)
Overview: May be used for founder incentives, investor alignment, and exit strategy alignment. For that they can be issued only at the time of exit.
Example: Series A founder owns less than 15% of fully diluted capital, and that raises concerns of the investor: Flowering share, among other terms, may be an option to level incentives between investor and founder of the company.
Growth Shares

Variation of incentive option stock, but this one focuses not on exit but acts more like a reverse ratchet where the founder (or key employees) can gain a portion of shares in the case of a certain growth threshold being met (i.e. higher company valuation). In this case it is a share acquisition arrangement involving a special class of shares which attracts no value until the company reaches threshold. There can be a variation where the growth is defined not as a valuation but instead, revenue or GMV of the company.

Specification: Incentives for mid-term growth targets (ie valuation increase, special KPI targets).
Overview: Maybe used to motivate founders or key employees (on top of EMI stock, or when EMI stock is inapplicable). May serve as an alignment of interest for investors and founders when a downround is happening (ie investor and founder may be issued those to earn back some of a lost value if valuation of the company exceeds a certain threshold)
Example: Series A founder owns less than 15% of fully diluted capital, early investors also took a hit in a down round. To incentivise the founder to push harder, a united investor board may decide to issue a specific growth share plan if the company exceeds a specific KPI which can be either valuation or revenue or both.
Phantom Stocks

Phantom stock, or ‘shadow stock’, is a compensation method for founders/key employees, mimicking stock ownership benefits without transferring actual shares. It avoids equity dilution but results in cash payments taxed as ordinary income, potentially affecting a firm’s cash flow.

Specification: Incentives for short term needs of founders. Tied to the value of the company’s shares but doesn’t confer ownership and delivered in incentive in a form of cash.
Overview: On some occasion founders (as any human being) may face a need for a cash bonus, and instead of selling their stock, going through the rofr/rofo, approvals and etc, the board can chose to motivate them differently and issue a specific instrument for a direct cash incentive for the founder, should they hit a very specific KPI. It can also be issued to some key employees as an additional (or replacement) form of EMI stock option plan. This can however potentially affect a firm’s cash flow.
Example: Necessity for immediate cash payment for founder/sale team motivation etc.
Stock Appreciation Rights (SARs)

These are less common and a more complex tool but still a very interesting option to consider. SARs are a contractual agreement between a company and an employee, representing a commitment to reward the employee with the value of stock appreciation. This value is determined by the difference between the stock price at the time of exercise and the time of SARs allotment. It is less regulated and because of that there are more manoeuvres for structuring (specific KPIs, terms, vesting of the rights etc.). In most cases they are used to motivate employees rather than founders.

Specification: Provides value tied to stock appreciation but not ownership.
Overview: Can be used to reward employees for company growth without issuing actual shares.
Example: A company granting SARs to executives, allowing them to benefit from stock price increases without dilution.
Comparison Table

For tech startup founders navigating the complex landscape of equity instruments, understanding the nuances of flowering shares, phantom stocks, SARs, and growth shares is essential. Each instrument offers unique benefits and challenges, and the choice will depend upon the specific needs and goals of the company.

There are of course no unified solutions and all cases are unique (as well as the possibility of using a specific instrument), but those are some of the most common options which enable founders to overcome difficult situations and continue to push on further!

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