Founder Anti-Dilution Protection - Man Bites Dog

Edwin L. Miller Jr., Partner, Sullivan & Worcester LLP


In an interview last year, Facebook CEO, Mark Zuckerberg, was asked about the Microsoft investment valuing Facebook at an astronomical $15 billion. He responded, "We wanted to raise money with the smallest dilution possible and on the most favorable terms." That sounds like good advice from the guy whom Forbes magazine referred to last year as the "youngest ever self-made billionaire."

It has become increasingly clear over the last ten years that the principal risk for entrepreneurs in accepting a venture capital investment is post-Series A dilution of their equity position. Other risks in taking money from outside investors have been clear for much longer. These risks include valuation risk–whether the entrepreneur has surrendered too much equity in the company in exchange for the amount of the investment. Another risk is the flip side of valuation risk–not taking enough money to accomplish promised near-term goals. In addition, a founder has always had the risk that he or she would lose a portion of his or her equity through vesting/forfeiture provisions.

But given the wash-outs associated with the burst of the Internet bubble, the subsequent tightening of investment standards and the frequency of “down-round” financings (the vc equivalent of the droit de seigneur), many experienced entrepreneurs have become reluctant to seek venture capital funding for new ventures and have turned instead to larger angel rounds or investments from alternative sources, like strategic partners or hedge funds. Some think that these deals are simply less desirable deals that the VCs have turned down, but increasingly that is not the case.

So, for founders who have the leverage to do so, or for venture funds or other investors as a possible favorable differentiating factor for prospective investee companies, some protection for the founders from subsequent dilution may be worth pursuing.

One approach that has begun to be used is to adopt a program for one or more founders (or senior executives) that is similar in concept to the “stay bonus” or “sticking bonus” contracts that are adopted by astute boards of directors when a possible acquisition of the company is on the horizon. Those contracts essentially say that if the individual remains an employee of the company at the time of the sale of the company, or remains an employee of the company for some period after the acquisition, the employee gets a bonus that is either a fixed amount or is tied to a percentage of the sale price of the company. A derivative approach for a founder of an early stage company would be (subject a number of complications discussed below) that the founder and the company would enter into a contract that specifies that the company must pay to the founder, simultaneous with an acquisition, an amount equal to a specified non-dilutable percentage of the gross amount payable to the company’s stockholders in the acquisition minus the amount otherwise payable to the founder with respect to his or her equity in the company. This percentage would vest according to the same schedule as the founder’s sweat equity, and the vested percentage (including full acceleration for founders who remain employees at the time of the acquisition) would be payable on the acquisition. In other words, the founder would get the full percentage if employed by the company at the acquisition, or, if the founder quit before there were an acquisition, the founder would only get the vested percentage. An IPO could be treated the same as an acquisition, with the founder receiving an amount of stock (or option) so that the founder would have his or her specified percentage of the pre-IPO fully diluted equity.

This program has one very significant advantage over other forms of dilution protection, such as a warrant guaranteeing a specified percentage of the common equity at the time of a liquidity event. The founder under this program effectively would be a creditor of the company who would not be subject to the prior (and dilutive) claims of existing and future issuances of preferred stock. Here the founder’s interest would be a contractual obligation at the company level, but in reality it is an equity derivative because the amount of the obligation is tied to the proceeds payable to the equity holders of the company on an acquisition.

One significant disadvantage of this type of program as compared to owning stock is that the proceeds to the founder would be taxable as compensation income, rather than as a capital gain. In a cash acquisition, this tax treatment would effectively result in lower after-tax proceeds than the percentage-equivalent equity position, although there would be no issues regarding the founder’s ability to pay the tax in a cash acquisition. On the other hand, if the acquisition were for equity of the acquiror, there is a possible planning issue in that the founder must be able to sell the equity in order to pay the tax on the receipt of the acquisition proceeds if it is not a tax-free reorganization. In a private/private acquisition, the founder’s interest in the program would simply carry over to the surviving company, and the bonus would be reduced based on the share of the surviving company’s equity initially held by the shareholders of the founder’s company.

If implemented at an early stage in the company’s lifecycle, a number of drafting and planning considerations must be addressed, some of which are discussed above, including:

  • Should the participant’s payout be based partly on how long the participant works for the company before the acquisition occurs? In other words, should the founder’s percentage interest be subject to vesting? For all of the reasons that vesting in common equity makes sense for the company, vesting in this sort of program makes sense as well.
  • Should vesting be accelerated in whole or in part if the participant is terminated without cause or quits for good reason? More senior executives are attempting to get some preferential treatment under these circumstances based on fairness arguments even though these provisions are rare for the rank and file.
  • Should vesting be accelerated, in whole or in part, on the acquisition? Should vesting be subject to a double trigger where the founder continues to vest after the acquisition but fully vests if he or she is terminated without cause or quits “for good reason.” In this event, there would have to be a retroactive true-up of the bonus. This is awkward since the acquirer would be liable for a contingent payment that could be substantial; on the other hand, stay bonus programs present the same problem but likely with much less onerous economics.
  • Should the vested portion of the participant’s interest be forfeited completely in the event the participant quits employment without good reason?
  • What happens if the acquisition is a sideways merger, that is, a merger with another private company? This presents a tricky planning and drafting issue. The typical provision in a stock option plan is that the option holder, on exercise of the carried-over option after the acquisition, gets what he or she would have received if the option had been exercised prior to the acquisition. If two private companies merge, then the value of the combined business increases. Giving the founder the same percentage protection as he or she had before the acquisition would be a windfall. The analogy to the typical stock option plan would be to give the founder continuing anti-dilution protection, but to multiply the founder’s guaranteed percentage by the percentage of the combined company that the shareholders of the founder’s original company own immediately after the acquisition.
  • Should an IPO be treated as a liquidity event similar to an acquisition? One would think so because having the contract survive the IPO would create unusual disclosure and market issues for the IPO and the subsequently traded public company. Paying a taxable bonus on an IPO, rather than on a cash or tax-free acquisition, will create liquidity problems for the founder which are not easily remediable. The bankers would not want to see the founder sell shares in the market before lock-up expiration in order to pay the tax, the market may not be sufficiently liquid regardless, and lastly a company loan might be prohibited under Sarbanes-Oxley depending on the founder’s officer status at the time of the IPO.
  • Should any proceeds from the participant’s sale of equity be a credit against the payout? This question also arises with respect to a prior sale or transfer. A reduction would appear to be sensible because the rationale for this sort of program is protection against “overly dilutive” future dilution, not a simple increase in the founder’s equity position. Other related questions are whether the reduction itself should itself be reduced by what the founder paid for his or her stock. The answer presumably is “yes.” Also, how are pre-acquisition dividends, ordinary and extraordinary, treated – should they reduce the amount payable to the founder? What if, for example, the company does a pre-acquisition spinoff or recapitalization? A warrant would normally contain a provision that the warrant holder on exercise would receive what the warrant holder would have received if he or she had exercised the warrant prior to the extraordinary event. That would be difficult to implement here. Perhaps the founder could receive his or her guaranteed percentage in the spun off company but without further anti-dilution protection.

Attached hereto is a sample agreement that attempts to implement this approach and deal with most of the foregoing issues.


Founder Anti-Dilution Agreement

Agreement, dated as of [·], between Xyz Inc., a Delaware corporation (the “Company”), and [·] (“Founder”).

It is agreed as follows:

1. Definitions. The following terms shall have the following meanings:

Acquisition” shall mean (i) the sale of the Company by merger in which the shareholders of the Company in their capacity as such no longer own a majority of the outstanding equity securities of the Company (or its successor or parent, if applicable); (ii) any sale of all or substantially all of the assets or capital stock of the Company; or (iii) any sale of a majority of the outstanding shares of capital stock of the Company; or (iv) any other acquisition of the business of the Company by grant of an exclusive license to the Company’s technology or otherwise.

Base Amount” shall mean the proceeds distributable or paid to the stockholders of the Company in exchange or payment for their stock in the Company upon an Acquisition [up to a maximum of $ [·] in cash or value].

Bonus Amount” shall mean an amount equal to [·]% of the Base Amount. The Bonus Amount shall be paid at the same time as the proceeds are distributed or paid to the stockholders, shall be paid in the same form of consideration as the stockholders receive, and shall be on the same terms, including, if applicable, a requirement to deposit a pro rata amount thereof in escrow.

Cause” shall mean Founder’s (i) willful act of personal dishonesty, gross misconduct, fraud or misrepresentation in connection with his responsibilities as an executive officer or employee of the Company that is seriously injurious to the Company; (ii) conviction of or entry of a plea of guilty or nolo contendere to a felony; (iii) willful and continued failure to substantially perform his principal duties and/or obligations of employment (other than any such failure resulting from incapacity due to bona fide physical or mental illness), which failure is not remedied within a period of thirty (30) days after receipt of written notice from the Company, specifically identifying the manner in which the Company believes that Founder has not substantially performed his duties and/or obligations; or (iv) an intentional material breach by Founder of any provision of any confidentiality, invention assignment, non-competition or non-solicitation agreement with the Company, which breach is incurable or, if curable, is not remedied within a period of thirty (30) days after receipt of written notice from the Company specifically identifying the manner in which the Company believes that Founder has materially breached such agreement.

Constructive Termination” shall mean that, without Founder’s written consent and without Cause, any of the following events occur and the Company has failed to cure such event within ten (10) business days of written notice from Founder:

(i) a reduction of [·]% or more of Founder’s base salary on the date hereof;

(ii) a reduction of [·]% or more of Founder’s target bonus opportunity with the Company (for the avoidance of doubt, a reduction in actual bonuses paid to Founder which is either (1) directly attributable the financial performance of the Company, or (2) directly attributable to Founder's failure to achieve individual quotas or objectives, shall not be considered a reduction in "target bonus opportunity");

(iii) a substantial reduction, without good business reasons, of the facilities, fringe benefits or perquisites available to Founder immediately prior to such reduction); or

(iv) the relocation of Founder’s primary workplace to a location more than [·] miles away from his workplace in effect immediately prior to such relocation.

Private Transaction” shall mean any Acquisition other than by an entity the common stock of which is registered under the Securities Exchange Act of 1934 and which common stock is traded on a national securities exchange or on an established electronic trading market.

Qualified IPO” shall mean a firm commitment public offering of the Company’s common stock in which the lead underwriter is of national or regional standing and immediately after which the common stock is traded on a national securities exchange or on an established electronic trading market.

"Permanent Disability" shall mean that Founder has been unable to perform his employment duties as the result of incapacity due to physical or mental illness, and such inability, at least twenty-six (26) weeks after its commencement, is determined to be total and permanent by a physician selected by the Company or its insurers and reasonably acceptable to Founder.

Sale Transaction” shall mean an Acquisition that is not a Private Transaction.

2. Anti-Dilution Payment. Subject to paragraph 3 below, concurrently with the closing of a Sale Transaction, the Company or its successor shall pay, or cause to be paid, to Founder a bonus (the “Net Payment Amount”) equal to (i) the Bonus Amount multiplied by the Vested Percentage (as hereinafter defined) minus (ii) the proceeds receivable by Founder from the disposition in the Sale Transaction of any equity interest in the Company held by Founder immediately prior to the consummation of the Sale Transaction. In the event that Founder has previously sold or otherwise disposed of an equity interest in the Company, there shall also be deducted from the Net Payment Amount, an amount equal to (i) the per share consideration payable to Founder with respect to his shares of Common Stock immediately prior to the consummation of the Sale Transaction multiplied by (ii) the number of shares previously disposed of, with appropriate adjustment for stock splits, recapitalizations and the like and on an as-if exercised or converted basis. For the avoidance of doubt, the bonus will be payable whether or not Founder is then an employee or service provider of the Company. In the event of a Private Transaction, Founder shall be entitled at his election to either (i) receive a portion of the consideration otherwise distributable to the stockholders of the Company with respect to their stock equal to the Net Payment Amount or (ii) defer payment of the bonus obligation and instead have it carried forward, in which case the Base Amount for purposes of determining the Bonus Amount applicable to any subsequent Sale Transaction shall be multiplied by the percentage of the Company’s or successor’s equity owned immediately after the Private Transaction by the stockholders of the Company in their capacity as such. There shall be only one bonus paid pursuant to this agreement.

On the date hereof, Founder’s “Vested Percentage” shall be [·]%. The remaining [·]% shall vest in equal quarterly installments on each [·] [·] [·] and [·], beginning on [·], 200[·] and ending on [·], 200[·], provided that if at any time (a) Founder terminates his own employment with the Company for reasons other than for a Constructive Termination, Permanent Disability or death or (b) the Company terminates Founder’s employment for Cause, all additional vesting shall terminate. If, at any time, (i) the Company terminates Founder’s employment without Cause, (ii) Founder terminates his employment due to a Constructive Termination or a Permanent Disability, or (iii) in the event of Founder’s death, the Vested Percentage shall be 100% thereafter. In addition, if Founder remains an employee of the Company immediately prior to the closing of a Sale Transaction, the Vested Percentage shall be 100%. [Or Founder must remain with the successor for a specified period of time assuming he or she is offered employment on terms comparable to the compensation and benefits prior to the Acquisition.]

3. Stock Option Exercisable in Connection with Qualified IPO. The Company hereby grants Founder an option, which option shall only vest and be exercisable upon the consummation of a Qualified IPO, to purchase a number of shares of Common Stock, at a purchase price of $0.001 per share, which is equal to (i) [·]% of Common Stock outstanding immediately prior to the consummation of the Qualified IPO, calculated on a fully-diluted basis (assuming full conversion or exercise of all outstanding securities into Company Common Stock), minus (ii) the number of shares of Company Common Stock already owned by Founder on a fully-diluted and as-converted to Common Stock basis without regard to this agreement. There shall be deducted from such number of shares of Common Stock otherwise issuable, the number of shares of Common Stock previously sold or otherwise disposed of by Founder, with appropriate adjustment for stock splits, recapitalizations and the like and on an as-if exercised or converted basis. Notwithstanding anything to the contrary in this agreement, if a Sale Transaction occurs prior to a Qualified IPO, the option referenced in this paragraph 3 shall automatically terminate upon the consummation of said Sale Transaction, and if a Qualified IPO occurs prior to a Sale Transaction, the Company’s obligation to pay Founder the Net Payment Amount upon a Sale Transaction shall automatically terminate upon consummation of the Qualified IPO.

4. Withholding. The Company shall deduct from any payments made pursuant to this agreement an amount equal to the federal, state, local and foreign taxes, if any, required by law to be withheld by it with respect to such payments.

5. Non-Assignability. Founder shall not have the power or right to transfer, assign, mortgage, or otherwise encumber his rights under this agreement (except by will or the laws of descent and distribution); nor shall such interest be transferable by operation of law in the event of Founder’s bankruptcy, insolvency, divorce or separation. This agreement shall be binding upon and shall inure to the benefit of the Company and its successors and assigns. The Company shall require that any successor assume its obligations hereunder, and any such successor shall be deemed substituted for the Company under this agreement for all purposes provided that this agreement shall terminate once the Net Payment Amount has been paid in full.

6. Notice of Record Date. In the event of an Acquisition or Qualified IPO, then the Company will send or cause to be sent to Founder a notice specifying the effective date on which such transaction is expected to take place, and in the event of an Acquisition, the time, if any is to be fixed, as of which the holders of record of the Common Stock shall be entitled to exchange their shares of stock for securities or other property deliverable upon such Acquisition, and the amount per share and character of such exchange that is applicable. Such notice shall be sent at least 10 days prior to the record date or effective date for the event specified in such notice.

7. Miscellaneous.

(a) Service Provider Rights. This agreement does not confer upon any Founder any right to continued employment or service with the Company in any position for any particular period of time. Subject to any rights of Founder in a separate employment or consulting agreement with the Company, Founder’s service provider relationship with the Company shall at all times be “at will,” which means that Founder and the Company each are free to terminate the relationship at any time with or without cause and for any or no reason.

(b) Effect on Other Benefits. Any payments made pursuant to this agreement shall not be counted as compensation for purposes of any benefit plan, program or agreement sponsored, maintained or contributed to by the Company unless provided for in a specific reference to this agreement in such benefit plan, program or agreement.

(c) Unfunded, Unsecured Obligation. This agreement shall at all times be entirely unfunded and no provisions shall at any time be made with respect to segregating assets of the Company for payment of any benefits hereunder. Founder, his beneficiary, and any other person having a claim for any unpaid amounts under this agreement shall be unsecured creditors.

(d) Governing Law. This agreement shall be governed by and construed in accordance with the laws of the state where Founder is providing services to the Company at the time of its execution.

(e) Severability. In the event one or more of the provisions of this agreement should, for any reason, be held to be invalid, illegal or unenforceable in any respect, such invalidity, illegality or unenforceability shall not affect any other provisions of this agreement, and this agreement shall be construed as if such invalid, illegal or unenforceable provision had never been contained herein.

(f) Amendment and Waiver. This agreement may be amended or modified, and the obligations of the parties hereunder may be waived, only upon the written consent of the Company and Founder.

(g) Successors and Assigns. The terms and conditions of this agreement shall inure to the benefit of and be binding upon the respective successors and assigns of the parties.

(h) Notices. All notices required or permitted hereunder shall be in writing and shall be deemed effectively given: (a) upon personal delivery to the party to be notified, (b) when sent by confirmed facsimile if sent during normal business hours of the recipient, if not, then on the next business day, (c) five (5) days after having been sent by registered or certified mail, return receipt requested, postage prepaid, or (d) one (1) day after deposit with a nationally recognized overnight courier, specifying next day delivery, with written verification of receipt. All communications shall be sent to the Company at the address listed as its principal office on its website (to the attention of the chief executive officer), to Founder at the address set forth on the signature page hereof, or at such other address as the Company or Founder may designate by ten (10) days advance written notice to the other parties hereto.

(i) Counterparts. This agreement may be executed in any number of counterparts, each of which shall be an original, but all of which together shall constitute one instrument.

(j) Attorneys’ Fees. If any action at law or in equity (including arbitration) is necessary to enforce or interpret the terms of this agreement the prevailing party shall be entitled to reasonable attorneys’ fees, costs and disbursements in addition to any other relief to which such party may be entitled.

AGREED TO as of the date first above written.


By: ______________________________

Name: ___________________________




Address: ________________________


Edwin L. Miller Jr.,, Partner, Sullivan & Worcester, has practiced corporate and securities law for over 30 years. He has represented both issuers and underwriters in scores of IPO's, secondary stock offerings and other public market transactions that have raised billions of dollars. Mr. Miller has organized a number of private equity/venture capital funds and has represented venture capital firms and technology companies in venture financings throughout his time in practice. More recently, he has concentrated on the representation of emerging technology companies in their financing, technology transfer and acquisition activities. In addition, Mr. Miller has extensive mergers and acquisitions experience in both the public markets and in private transactions, representing both acquirers and sellers. Mr. Miller was the first associate and a partner for over 20 years at Boston's Testa, Hurwitz & Thibeault.

He is the author of two books: Lifecycle of a Technology Company - Step-by-Step Legal Background and Practical Guide from Startup to Sale and Mergers and Acquisitions - A Step-by-Step Legal and Practical Guide (Wiley, 2008). The author wishes to thank his colleagues, Harvey Bines, Aaron Fiske and Paul Oakley, as well as Jason Kuhns, Esq., for their comments.