Keeping it simple with employee share schemes, part 3: dilution
This part of the series looks at dilution, or rather protecting specific groups from dilution. You can set up an employee share scheme to protect specific groups from dilution, but I’ll explain below why keeping things simple (and not offering dilution protection to employee shareholders) is often best.
What is dilution?
When you think of your equity, you probably think about percentages (e.g. I’m a founder and I hold 30% of the equity, and we’re going to give 10% of the equity to employees). When it comes to the legal documents to give or transfer equity, you need to specify the number of shares (e.g. if your entire share capital is 1,000 shares, you would be giving 100 shares to employees).
When you raise money through an equity offering or give equity to employees, you almost always will be creating new shares. This means that the percentage of equity people previously held will go down (that’s dilution – the reduction of in the percentage holding of existing shareholders by new shareholders).
What’s the problem?
Let’s say you promised an employee 5% of the equity, and then you gave them the relevant number of shares. You then create more shares for other employees or to raise money, therefore reducing their percentage holding.
Have you broken your promise?
Well, yes you have.
What’s the solution?
There are two solutions:
- offer dilution protection;
- offer no dilution protection, and be clear when you’re offering equity that the shares will be subject to dilution.
What ways are there to protect employee shareholders from dilution?
There are almost infinite ways to achieve dilution protection, but they all boil down to the same idea:
You can’t give out more than 100% of your equity. To maintain someone’s percentage shareholding, they need to be topped up with extra shares. The fundamental question when designing dilution protection is this: who loses out to provide a source of those top-up shares?
Here a few examples of dilution protection mechanisms (see note 1):
- founders could grant options to the protected shareholder. Those options allow a protected shareholder to buy more shares at zero cost to reverse any dilution. Founders would be the source of the top up shares.
- a trust could be set up for the benefit of employees and gifted a pot of shares. The trust then grants options to a protected shareholder as above. The trust would be the source of the top up shares.
- you could create a special class (type) of share. The rights of the shares would give a protected shareholder a fixed percentage of the equity. All non-protected shareholders would be the source of the top up shares.
What’s wrong with these approaches?
For a start, they normally require bespoke drafting. The cost and time involved can exceed that for the rest of your employee share scheme.
But there’s also a more significant consideration. The business case for giving away equity must be that shareholders benefit from the transaction. So, you need to ask yourself this:
will the business get something in return for the equity that will grow the company as a whole? And will that growth be enough to compensate shareholders for the reduction in their percentage holding?
Answering the questions above should be straightforward for raising finance: will the extra cash fund growth that exceeds the dilution?
You should also be able to answer a similar question with giving equity to employees: will motivating, recruiting or retaining these employees with equity grow the business by more than the dilution?
If the answer is no, then you don’t have a business case for offering equity. It’s not in the best interests of the company and its shareholders.
What can be done with an employee shareholder who insists on dilution protection?
An employee shareholder should agree to dilution if:
- you have a business case for offering the equity,
- the shareholder believes the business case, and
- the shareholder will remain an employee shareholder for a sufficiently long term to benefit from the resulting growth.
If you’re under pressure to give dilution protection to employees, think about the cause of the concern. Is your business case for offering equity solid? Have you communicated it properly? If so, why does the employee shareholder not think they would be better off?
When might dilution protection be appropriate?
Dilution protection for employee shareholders should be a last resort. However, for investors, there are times when dilution protection may be appropriate (for example, if you are going to raise finance at a low price). That’s beyond the scope of this article.
Is dilution protection the same as a dilution limit?
Dilution protection is an automatic way of topping up protected shareholders – it prevents dilution.
A dilution limit allows dilution. Typically, it will be in agreement with new investors, and it will allow, say 10% of the equity to be given to employees without further approval from the investors.
Should dilution limits be included in share schemes?
If you have agreed on a dilution limit, it will normally have been agreed with investors. The permission to offer equity up to that limit will be contained in a shareholders’ agreement with those investors.
There is no requirement for that limit to be included in the documents you use to give equity to employees (see note 2).
What does the simple approach look like?
It means no dilution protection for employees, so, in the documents you use to give equity to employees, there will be no reference to dilution.
You don’t need to think about dilution protection for future investors when designing your employee incentives. If investors later demand dilution protection, it will be documented in the agreements with those investors, and should not require you to amend your agreements with employees.