Facebook, share dilution and the future of early stage equity

A guest piece from Tom Davies, Chief Investment Officer at Seedrs, who puts a popular culture angle on an extremely important, but arguably arcane feature of early stage investment: pre-emption rights and the risk of share dilution.

High finance rarely permeates into popular culture. The few examples that we have – the RJR Nabisco LBO depicted in Barbarians at the Gate or the exploits of Jordan Belfort in The Wolf of Wall Street—manage both to capture the public imagination and become the stuff of lore in the world’s financial centres.

Another example comes from the film The Social Network, when Mark Zuckerberg diluted erstwhile business partner Eduardo Savarin’s shares in Facebook from 30% to less than 10%, costing him billions at the point of company’s IPO.

The risks of share dilution are very real for investors and business partners in early stage businesses, especially those without teams of lawyers to pore over contacts and engage with growing businesses as they proceed through funding rounds.

Seedrs is an equity crowdfunding platform that enables investors to share in the success of the businesses they choose to invest in.  A key part of that is ensuring investors’ interests are sufficiently protected. One of the ways we protect investors is by securing certain contractual rights in our shareholder agreements with funded businesses. These agreements contain similar terms that venture capital firms would expect.

Every time a company raises funds by selling equity, the company issues new shares to investors in exchange for their investment. In turn, this reduces the percentage share of ownership for each existing investor in the company. It’s like the investors have a smaller piece of a bigger pie, over time.

After multiple funding rounds, early investors who initially received large stakes in the business may find themselves with much smaller holdings when the company looks to exit or IPO.

This dilution effect is why pre-emption rights are so crucial for early-stage investors. Pre-emption gives investors the opportunity to invest in each future investment round in order to maintain their percentage ownership. In effect, it allows them to keep their slice of the pie the same size.

Pre-emption rights are also an important minority shareholder protection; they disincentivise the majority shareholders from issuing new shares to themselves at a lower valuation (like Zuckerberg did). If they were to do so, they would have to offer the low value shares to all shareholders.  For that reason, they are often seen by investors as the most crucial minority investor protection.

Seedrs secures pre-emption rights for ordinary investors and provides the practical facilities for investors to exercise these rights.  Running a pre-emption round for 100+ ‘crowd’ shareholders (as opposed to a small group of venture capitalists) would be impractical for most small businesses. Our model streamlines the process through a so-called ‘nominee structure’ and makes it possible for all investors to participate in future funding rounds via our platform.

While dilution can be seen as negative, it’s important to remember that, generally, additional fundraising means that a company is doing well and increasing in value. An investor may be holding a smaller piece of the pie, but the pie is usually getting more valuable.

Saverin eventually hired a team of lawyers to take his case to court, and settled for an undisclosed amount (probably billions). Unfortunately, smaller investors in early stage businesses may not realise they have been diluted until it is too late and too costly to resolve. We encourage investors in early stage equity to consider their contractual rights carefully—and to ensure that the platform that they are using are actually providing them with these rights in the first place. Without these rights, your investment may start to look more like a donation.