Founder Dilution

Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies. The information on this page should not be construed as legal advice.

At least once a week, someone asks me about how they can protect themselves against getting diluted unfairly, with specific reference to Eduardo Saverin and the Social Network.  Their concern is that their cofounders or future investors will be able to remove them and strip them of their stock.  I typically remind these people that Eduardo Saverin is a billionaire, and that the company did not ultimately strip him of his value.  A bit more detail follows:

The primary objective of reducing Saverin’s ownership in the company was not to strip him of monetary value (at least based on most of the emails/letters that are available). The concern was that he was lagging with his member vote (while the company was still a Florida LLC) that was required for the company to reorganize as a Delaware corporation and accept venture capital funding.  In order to circumvent the required vote, the company engineered a transaction whereby the Delaware corporation would be formed, and would acquire the Florida LLC.  The LLC members would get a portion of the newly formed DE-corp’s stock, with the remainder of the stock distributed to people other than Saverin (including the other member’s of the LLC).  The transaction was executed and the newly formed Delaware corporation went on to close the VC round.

At the time the transaction was contemplated, Mark Zuckerburg knew he would most likely have to settle with Saverin down the line.  The lawyers told him that Saverin could allege they were breaching their fiduciary duties to him.  But they did this out of a perceived necessity, with the understanding that they’d rather settle with him in the future than to be stagnant in the present.

Saverin sued.  They settled.  Saverin is worth $5.5 billion.

The takeaway is that it’s not easy for a company to shrink someone’s vested ownership.  There might be statutory mechanisms available, but those statutory mechanisms come with corresponding fiduciary duties and other legal protections.  In any case where one founder doesn’t have the same ability to maintain ownership through a transaction as the other founders do, they’re probably going to have the ability to bring a breach of fiduciary duty claim if the stock ever becomes valuable enough to make it financially worthwhile.

 

Related Pages:

Freezeout Mergers and Dilution
The Dilution Monster