BLIND SPOTS: ANTI-DILUTION CLAUSE

Introduction

Some years ago, Together with a set of #cofounders and after multiple meetings - the entire team arrived at a #dilutionclause that seemed solid at the time.

However, as the business evolved, I identified gaps that could create unintended consequences for founders, investors, and future capital raises.

This article walks through those challenges and explores potential solutions, providing a framework for structuring dilution clauses that balance #founderprotection with #investorfairness.

1. Lack of a Clear Mechanism for Founder Protection

Our original clause stated that founders' shares could not be diluted below 15% and 5%, respectively. However, it did not specify how this protection would be enforced. Would the company issue additional shares to the founders? Or would dilution simply stop for them while it continued for others?

👉 Lesson: Founder protection needs a defined mechanism, such as automatic share issuance, preferential equity rights, or buybacks.

2. Perceived Bad Faith in Dilution Allocation

If the founders are shielded from dilution while all other shareholders absorb its effects, does this create a fairness issue? Investors may see this as a bad faith transaction, where the burden of new capital raises falls disproportionately on them.

👉 Lesson: Consider weighted dilution structures where founders retain protection but still share some dilution risk.

3. What Happens When Capital Raises Exceed the 30% Equity Pool?

The original clause limited dilution to a 30% equity pool. But what if the company needed to raise beyond this? If the founders had already hit their minimum thresholds, how would new shares be allocated?

👉 Lesson: Dilution clauses should address future funding rounds, including structured dilution caps, performance-based thresholds, or phased dilution agreements.

4. Conflict Between Preemptive Rights and Anti-Dilution Protection

Many company articles provide preemptive rights, allowing existing shareholders to buy new shares before external investors. However, if founders have guaranteed anti-dilution protection, this creates a problem: There may not be enough available shares for preemptive rights to be exercised without diluting someone else.

👉 Lesson: Agreements should clarify who absorbs the dilution—the company (by issuing new shares), other shareholders, or new investors. Possible solutions include:

• Equity carve-outs for preemptive rights
• Dilution thresholds that adjust dynamically based on new capital inflows
• Founder dilution linked to performance milestones

The Revised Dilution Clause: Improvements and Open Questions

To address these issues, I revised the dilution clause in subsequent similar transactions to include:

✅ A defined mechanism for maintaining founder equity (reallocation, issuance, or another approach decided by the board).

✅ Uniform dilution across shareholders until founders reach their thresholds.

✅ A provision ensuring dilution applies proportionally unless the board determines otherwise.

However, even this revised version does not resolve all questions. Each startup’s situation is different, and dilution terms should be tailored to the company’s needs.

Final Thoughts: Building a Balanced Dilution Clause

A well-drafted dilution clause should:

✅ Clearly define how founder protection works

✅ Address potential fairness concerns for investors

✅ Consider long-term fundraising needs beyond an initial equity pool

✅ Align preemptive rights with anti-dilution mechanisms

At the end of the day, dilution is not just a legal issue—it’s a strategic one.

How a startup structures its equity today determines the incentives, relationships, and trust among stakeholders for years to come.

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