If a startup can always issue new shares, what value is there to stocks/options?

Question

Since in most startups the board can issue more shares at will, what does it mean for an employee to own X% of the shares? When signing up, can an employee protect himself from the company printing more shares after he leaves the company in a few years?

See What clause was used to dilute Eduardo Saverin's stake in Facebook Inc?

Edit - A company can just give every share holder more shares, except for person X, whom they wish to dilute (without any investment going into the company). Is this situation possible/legal?

Answer 1

The short answer, probably not much. Unless you have a controlling interest in the company. If at least 50%+1 of the shareholder votes are in favor of the dilution then it can be done. There are some SEC rules that should protect against corporate looting and theft like what the Severin side is trying to make it appear as happened. However it would appear that Severin did something stupid. He signed away all of his voting right to someone who would use them to make his rights basically worthless. Had he kept his head in the game he could probably have saved himself. But he didn't.

If your average startup started issuing lots of stock and devaluing existing shares significantly then I would expect it would be harder to find investors willing to watch as their investment dwindled. But if you are issuing a limited amount stock to get leverage to grow bigger then it is worth it. In the .com bubble there were quite a few companies that just issued stock to buy other companies. Eventually most of these companies got delisted because they diluted them selves to much when they were overvalued.

Any company not just a startup can dilute its shares. Many if not most major companies issue stock to raise capital. This capital is then generally used to build the business further and increase the value of all shares. Most of the time this dilution is very minor (<.1%) and has little if any impact on the stock. There are rules that have to be followed as listed companies are regulated by the SEC. There are less regulations with private corporations. It looks like the dilution was combined with the buyout of the Florida company which probably contributed to the legality of the dilution.

With options they are generally issued at a set price. This may be higher or lower than the reported sell price of the stock when the option is issued. The idea is over time the stock will increase in value so that those people who hold on to their options can buy the stock for the price listed on the option. I worked at an ISP start up in the 90's that made it pretty well. I left before the options were issued but I had friends still there that were issued an option at $16 a share the value of the stock at the time of the issue of the option was about 12. Well the company diluted the shares and used them to acquire more ISP's unfortunately this was about the time that DSL And cable internet took off so the dial up market tanked. The value eventually fell to .10 they did a reverse split and when they did the called in all options. The options did not have a positive cash value at any time. Had RMI ever made it big then the options could have been worth millions. There are some people from MS and Yahoo that were in early that made millions off of their options. This became a popular way for startups to attract great talent paying peanuts. They invested their time in the business hoping to strike gold. A lot of IT people got burned so this is less popular among top talent as the primary compensation anymore.

Answer 2

Companies normally do not give you X% of shares, but in effect give you a fixed "N" number of shares. The "N" may translate initially to X%, but this can go down.

If say we began with 100 shares, A holding 50 shares and B holding 50 shares. As the startup grows, there is need for more money. Create 50 more shares and sell it at an arranged price to investor C. Now the percentage of each investor is 33.33%. The money that comes in will go to the company and not to A & B.

From here on, A & C together can decide to slowly cut out B by, for example:

• Issuing more & more shares to A as bonus for his contribution over the years.
• "A" bringing in more personal money from outside and getting more shares at discounted price.
• Further dilution by issuing more shares to entity D and the money going into the company.
• All partners asked to bring in more money for new shares, and "B" not able to put in additional funds.
• "B" cashing out partly in the early days for smaller sum of money.

After any of the above the % of shares held by B would definitely go down.

Answer 3

It's called "dilution". Usually it is done to attract more investors, and yes - the existing share holders will get diluted and their share of ownership shrinks.

As a shareholder you can affect the board decisions (depends on your stake of ownership), but usually you'll want to attract more investors to keep the company running, so not much you can do to avoid it.

The initial investors/employees in a startup company are almost always diluted out. Look at what happened to Steve Jobs at Apple, as an example.