Maximizing Returns
Last Updated:
December 21, 2020

Anti-Dilution Protection for Angels

Slices of Pie


Providing Maximum Value and Protecting Your Angel Investment

Angel investors are often the catalyst that allows an entrepreneur to turn a dream into a tangible concept.

Whether the angel is a friend, family member, or mentor, they're investing in both the entrepreneur and the idea behind the business.

Angels often are high net-worth individuals who have excess capital to deploy and are looking to generate substantial returns with startups, develop their skills in their industry, or invest behind a change in the world that they want to see. 

Dilution is unavoidable if the start-up raises another round. The key thing is to focus on minimizing the dilution that an Angel experiences by focusing on what the Angel can control: adding value on the cap table, ensuring that there are reasonable protections in place and having a good relationship with the founding team. 

It can be complicated

Angels balance the desire for higher returns with the unpredictable nature of startups. On the one hand, Angel Investors invest in startups mostly because they invest in the entrepreneur rather than the idea behind the business.

On the other hand, the investor usually wants to generate a positive return on their capital. 

Dilution is unavoidable

As the startup grows, the founders will most likely require additional funding to scale their business.

When they take on additional capital, it will most likely dilute the shares of the angel investor. This is a risk known and accepted by most angels, but depending on how the deal is structured, an angel may give up more of their returns than is necessary.

Although dilution is unavoidable and is a sign of growth for the startup, angels should do their best to protect their investment and help the founders grow.

By understanding how dilution affects angel investments, the options available to help mitigate the impact of dilution, and nurturing the founders by providing value outside of their investment, they will minimize their risk and feel rewarded by their role. 

Pen and notebook
Your investment is diluted when more investors inject capital into the startup and more shares are issued


What is Dilution?

By their nature, Angels are typically the earliest investors in a startup. They help entrepreneurs get their ideas off the ground and assume an immense amount of risk because the entrepreneurs may not even have a minimum viable product yet.

If the startup survives its initial stages, it will most likely need additional capital to keep growing.

Venture Capital funds, crowdfunding groups, and other investment firms interested in the startup often require a large amount of equity in exchange for their investment. This leads to reduction of the Angel Investor’s ownership percentage of the company - known as dilution. 

How Does Dilution Impact Angel Investors?

Your Equity Stake Shrinks

The most apparent impact of dilution on an angel investor's position is the influx of capital and potential issuance of new shares and options.

As new investors pump capital into the startup, the initial investors' stake shrinks to accommodate the new ownership structure.

For example, if an angel investor owns 100,000 shares of a company with 1 million shares outstanding, for $10 per share, that represents a 10% stake in a company valued at $10 million.

If the startup performs well and attracts investment from a venture capital firm that generates a new share issuance of an additional 1 million shares, their 10% stake in the company shrinks to 5%.

If the share price stays the same, They will still have the same dollar investment, but their ownership claim will be cut in half. 

Money burning
Understanding how dilution impacts your investment enables you to get the most out of your experience as an angel investor


Their outsized risk loses its potential for excessive returns if the dilution terms are particularly unfavorable

Additional liquidity from venture capital firms can be a lifesaver for a startup because the market notices there is potential for success in this company.

However, the earliest investors, like Angels, run the risk of putting their return on the line if the initial investment agreement does not include any anti-dilution measures. 

Can Angel Investors Protect themselves from dilution?

Anti-dilution clauses

Although dilution is unavoidable for the most part, there are steps that angel investors can take to reduce the impact of share dilution on their investment.

These anti-dilution measures do not eliminate the effects of dilution from a subsequent round of funding. However, they can mitigate the extent to which they are diluted.

Types of Anti-Dilution

Full Ratchet

A full ratchet Clause protects the angel investor if more shares are issued at a lower price than paid. Although this protects the Angel, this is very rarely agreed to by Entrepreneurs and the presence of these clauses in early funding documents can seriously jeopardize the funding terms of following rounds. 

Full ratchet Clauses will convert whatever the investor's initial share price was into the current share price after funding. 

In our example above, the Share price dropped from $10 to $5; a full ratchet clause would convert the angels $10 shares into $5 shares, nearly doubling the amount of shares they have and maintaining their percentage ownership of the company.

Full ratchet causes are helpful for Angels because they are diluted last. However, they are not very favorable towards the founders because, in some cases, angel investors may own more of the company than the founders after a round of funding. 

Weighted Average

The weighted average conversion method is the more common and more founder-friendly dilution method for angels and other early investors.

New shares being issued, original share price, and new share price are all factored into a 'weighted-average' conversion price for the angel. 

This weighted average price is calculated differently depending on the formula used. However, it consistently helps angels protect their investment while simultaneously making sure the entrepreneurs are not being taken advantage of. 

Pro-rata

You can negotiate with the Founder to allow you a pro-rata right. This is a right to purchase shares up to the amount required to maintain your percentage ownership position in one or more future funding rounds. 

Using the example again, a pro-rata right would give the Angel Investor the right to buy another 5% of the company at the price per share of the new funding round. This would maintain the Angel Investor’s ownership position of 10% after the round.   

Man giving presentation
Angel investors contribute so much more than financial capital; your advice and influence can be the catalyst for your founders’ success


Work with your founders to ensure you have options

This is by far the best option. Angel Investors provide so much more to startup Founders besides capital. Often the investor is a friend, a family member, or a mentor to the entrepreneurs. They want to see them succeed regardless of how their investment performs.

Not only do angel investors help companies get off the ground, but they also provide the infrastructure and potential network and education that the entrepreneurs are lacking.

Suppose you do an excellent job as a mentor and advisor. In that case, the startup founders are much more likely to help ensure you have a fair deal and assist in protecting your investment.` 

Conclusion

Angel investing can be extremely rewarding and profitable

Angel Investors exist to help budding entrepreneurs get a chance at starting their business and to hopefully enjoy outsized returns on their investment.

Understanding share dilution and protection options can protect your investment

Share dilution is a part of growth for a successful startup. When new investors decide to take a stake in the company, the liquidity they provid, or growth that they allow, will affect  the price of the equity and the percent of the company that the Angel owns.

If the deal is done well, it will help the startup continue to grow and succeed. While you may not have as large of a stake as you used to, the piece that you do have will hopefully be more valuable. 

Always read the fine print and ask questions about subsequent investment

If you want to remain in good standing with the company and protect your investment, read the fine print of your investor agreement.

Checking the fine print of the deal documents and understanding how future financing rounds will affect your ownership in the company. This will prevent you from getting blindsided and encourage you to continue to invest in the Founders with more than just money. 





Sources:

https://www.holloway.com/g/angel-investing/sections/calculating-ownership-and-dilution

https://www.investopedia.com/terms/a/anti-dilutionprovision.asp

https://www.startupblog.com/anti-dilution-provisions-for-preferred-stock/

https://angelinvestingschool.com/dictionary/anti-dilution-protection

https://blog.ourcrowd.com/angel-investing-a-three-part-guide-to-earning-your-wings-1-3/

https://seraf-investor.com/compass/article/angel-fundamentals-understanding-equity-deal-terms-investor-rights-protection

https://blog.vcexperts.com/2015/03/12/three-basic-rules-dilution-dilution-dilution/

http://www.venturechoice.com/articles/dilution_basics.htm

https://www.forbes.com/sites/mergermarket/2020/01/06/biotech-angels-bedeviled-by-dilution/?sh=6267c7566486