When you have a startup and you start bringing in funding, you're proud that people want to invest but, somewhere in the back of your mind your conscious of the fact you're slowly chipping away at your own personal equity position. As you bring in more investment, you become more aware of this fact. As you sell shares, your own overall percentage of ownership decreases - dilution.
Often investors will look for a provision to their investment called anti-dilution rights. This gives the investor the right but not the obligation to put additional money into a company as other investment comes in. This way the original investor can maintain their current percentage ownership of the company in the long run - all the way to exit when the company is valued most. Many founders don't like this idea because they feel it forces them to sell more of the company than they want to with each new round of investors. The brand new investors want a certain percentage ownership or the investment is not meaningful enough for them. At the same time, the old investor doesn't want to give up their percentage ownership either. At this point, it's typically the founders who end up losing the percentage that the old money wants to maintain.
Most founders really hate being in this position but there are some really great things about this if you shift your thinking.
Making your selling easier. If your old investors are determined to kick in their anti-dilution rights then you can just work with that scenario. If they have 20% of your company then plan to raise less money with each round or each bridge (small raise of funds) round. If you treat fund raising as a sales pursuit then you already have 20% of your selling "in the bag". That's not a bad thing.
Kicking in cash when your trading in labor. Many start ups can't afford to pay every person or services company they need. Many start ups will convert billable hours as a cash investment and issue shares to those vendors. Although often necessary, you can end up issuing a lot of shares (diluting you) with no operating cash (hard investment dollars) to show for it. But wait, remember those anti-dilution rights, yes, this is when they kick in as well. As you are issuing shares to convert vendor debt into equity (shares), you are diluting the shareholders. This kicks in the anti-dilution rights of prior investors. So they must either invest money to maintain their percentage of ownership (hard dollars) or they get diluted along with you the founder.
If we use the example of an investor with 20% ownership and anti-dilution rights, then converting $100,000 in legal expenses to stock issuance would require that investor to pony up $20,000 in hard cash. That is money in the door. If you use this approach strategically then you may want to convert debt to equity at a particular month when your cash flow is low or delayed. This could end up making up for having to make a high interest loan or use a bridge loan that extracts a hit to your company's upward valuations.
Turn lemons into lemonade, let those investors have their anti-dilution rights and leverage the agreement to help grow your business. Best of success!
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