Should Early Investors Receive Non-Dilutable Shares?
The decision to offer non-dilutable shares to early investors can significantly impact the long-term success of a startup. While this approach might seem beneficial in the short term, it often leads to complex issues that can hinder future growth and fundraising efforts. In this article, we explore the pros and cons of providing non-dilutable shares to early investors and suggest alternative solutions that can better protect both investors and the company.
Understanding Non-Dilutable Shares
Non-dilutable shares are a type of stock that does not decrease in value when new shares are issued. This means that when the company raises additional capital, the percentage of ownership held by non-dilutable shareholders remains the same, even if new shareholders join the investment round. However, this also means that if the company performs well and becomes more valuable, the non-dilutable shareholders may not benefit from this increased valuation.
The Risks of Non-Dilutable Shares
Given the potential downsides, we strongly advise against granting non-dilutable shares to early investors. One of the main risks is that subsequent investors may refuse to invest in the company if existing shares are not subject to dilution. This can lead to a situation where the company cannot attract new capital, ultimately hindering its growth and potential exit strategies.
Additionally, the presence of non-dilutable shares can complicate management changes and exit strategies. For example, if a management buyout is planned, non-dilutable shares can become a significant obstacle, leading to potential conflicts and delays. Furthermore, the company’s founders and management might be forced to dilute their own ownership stakes to accommodate new financiers, potentially eroding their control and influence over the business.
Our experience with early seed investors shows that it is better to own a small percentage of a highly valuable business than a significant share of a less profitable one. Over time, the value of the shares can increase exponentially, making the initial investment highly rewarding. Investing in a more valuable company also reduces the risk of losing the initial investment, as the company has a higher chance of becoming successful.
Alternative Solutions: Convertible Loans and Convertible Notes
If you are considering offering non-dilutable shares to early investors, we recommend exploring alternative solutions. One effective approach is to grant early investors convertible loan stock. This allows the early investors to choose whether to continue holding their loan stock or convert it into ordinary shares. This flexibility ensures that early investors have the option to benefit from the company’s growth, while still allowing for future dilution.
Convertible loan stock can be structured in a way that provides early investors with the security of their initial investment, while still allowing the company to raise additional capital without compromising their ownership interests. This approach can be particularly beneficial when the company is poised for significant growth and needs to attract new investors who may have different risk profiles.
The Trade-offs of Non-Dilutable Shares
The decision to offer non-dilutable shares to early investors involves a trade-off. While these shares can provide initial investors with a sense of security and ownership, they can also create long-term challenges and potential conflicts. As such, it is crucial to weigh the benefits against the potential drawbacks before making a final decision.
Ultimately, the best course of action is to prioritize the long-term success and growth of the company. If you need to attract future capital, it is advisable to have some form of dilutable shares to accommodate new investors. This approach ensures that the company can continue to grow and thrive, while still providing early investors with the opportunity to benefit from the company’s success.
The final decision should be carefully considered and discussed with all stakeholders, including early investors, management, and potential future investors. By understanding the full implications of non-dilutable shares, you can make an informed decision that aligns with the company’s long-term goals and maximizes the potential for success.