I don't know how this works, but my question is, on a funding round, couldn't the C suite just allocate themselves additional equity in proportion so that their total value remains the same?
They could, but the shares represent value - and that money needs to come from somewhere. Simple, but extreme example: A company is valued at 10 million gobbledoks, and the C-Suite holds 10%, representing 1 Million valuation. Now the company takes 10 Million gobbledoks Investment that end up in cash on the companies bank account. This raises the the valuation to 20 Million.
Under simple dilution rules, the Investor takes 50%, and the existing shareholders are diluted to 50% of their stake - the C-Suite owns 5% of 2 Million, 10 million as before.
If the C-Suite demands that their equity proportion remains at 1%, they’d suddenly own a stake representing 2 million valuation. That difference needs to come from somewhere.
There is actually a sense to the dilution. If I have something I think is worth $10m, and I'm asking someone else to give me another $10m, doesn't it make sense for that person to own 50% of the company? Why would any investor give you $10m wile receiving no ownership of the company? How are you going to give these newer investors ownership, if you don't reduce the ownership of everyone else?
The claim in the tweet was that they got 1% of the value of the diluted shares: e.g., on paper they should own 1% of $100m, but somehow they only got $10k out of it. There does seem to be a culture of this going around now -- the VC version of "Hollywood accounting". In a lot of situations it doesn't make much sense to me -- is it really worth poisoning the well of startup talent for the VCs to get $95m instead of $85m?
> If the value of a company is $10m and the company asks an investor to give $10m in exchange for equity, the investor should own 100%.
That's not investing, that's buying. Buying means the buyer gives $10m to the previous owners, at which point as you say, the previous owner owns 0% and the new owner owns 100%. But the company is in the same position as it was before -- the same amount of cash on hand as it did before.
For investing, you're putting cash into the company's account, which raises the total value of the company.
Value of the company before investment: intangibles + pre-investment cash - debt = $10m
Suppose I own 10% pre-investment; 10% of $10m is $1m of estimated value.
Value of company after the investment: intangibles + pre-investment cash - debt + $10m == $20m
Now I own 5% of $20m, which is still $1m of estimated value. The investor owns 50% of $20m, which is still $10m of estimated value.
In practice of course, there are different classes of shares which end up being paid out differently.
Legally speaking, it’s probably possible. Practically speaking it almost certainly a guarantee that the company will never see outside investment. On every round someone would need to pony up the cash to fill that employees stock. Anti-dilution clauses exist, but they never work like that.
Such a privilege is also likely to be almost worthless - if the company succeeds and the round makes it worth more, you’ll win even with dilution. If the company doesn’t, then other clauses such as liquidation preferences will make your stock worthless, regardless of how much you own.
The difference is that if the company succeeds, an employee afforded this provision is guaranteed to make $X.
Without this provision, it's possible in many ways for the employee to be left with far less than $X, even if the company succeeds. In some ways <<<<<<$X.