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PSA for Startup Founders - Your Dilution and Preference are Ruining Your Upside

I recently read two threads that underscore the severity of impact of dilution, preference overhang and structure on founder returns. In one instance, a founder's $525M company sale resulted in approximately $0 personal return. In another case, a founder who declined a $50M acquisition offer later sold the company for $1B, yet reportedly received no greater personal return than the initial $50M offer would have provided. While I’m not privy to the exact details, these outcomes likely stemmed almost entierely from dilution, structure and preference overhang.

Dilution in private investing refers to the decrease in ownership percentage of existing shareholders when new shares are issued. This typically occurs through:

• 💰 New funding rounds (Seed, Series A, Series B); funding rounds typically dilute ownership 10-30% in each round

• 👥 Equity issuance to key managers, advisors, board members

• 🎁 Option pools of 10-20%+ for employee compensation

• 📈 Corporate Actions including warrant excercises

• 👨‍💼M&A/Strategic Events including stock-based acquisitions

Historical examples illustrate the extent of potential dilution. Mark Zuckerberg retained approximately 28% ownership at Facebook's IPO, while Pandora's three founders collectively held just 2% at their IPO. The other 98%? The remaining ownership was likely distributed through early financing rounds and employee equity packages, with some potential secondary sales during the private phase.

The other major impact is share class and preference. Share classes are different types of stock that a company issues, each with its own set of rights, privileges, and restrictions. 

Founder shares are often “common shares”, meaning these are subordinate to preferred shares in the event of an acquisition and typically last to receive payouts in an M&A event. Preferred shares are paid out before common shareholders if the company is liquidated or sold.

Preferred shares also usually come with a 1x liquidation preference. The liquidation preference is the right of preferred shareholders to receive a specified amount before common shareholders in an M&A event and often expressed as a multiple of the original investment (e.g., 1x, 2x, 3x). As an example, a 2x preference on a $1 million equity investment means the investor gets $2 million before common shareholders receive a distribution.  

There are other events and structures that can have substantial impacts on M&A including balance sheet debt and complex structured terms. Debt specifically sits above equity in a normal distribution so will be paid out before preferred, which will be paid out before founder shares (or common shares). Notably in IPOs, it's common for automatic conversion of preferred shares to common, so for IPOs, while dilution is an issue, share class isn’t as big a deal as far as actual payout. 

Okay so, back to our examples. The first tweet came from Rohit Mittal off the back of Truepill’s exit for $525 million by Ireland's LetsGetChecked. According to Rohit Mittal, the founders walked away from nothing despite being valued at $1.6B at its peak and selling for $525M. The Founder of Truepill reportedly received $0 in severance and sold $0 in secondary stock. 

Based on public information, Truepill raised approximately $370M in venture funding. Assuming standard market terms with a minimum 1x liquidation preference, investors would be entitled to at least $370M before common shareholders (including founders) receive proceeds. The reported acquisition structure included $25M in upfront cash and up to $200M in performance-based earnouts.

Given the $25M immediate cash consideration falls significantly below the estimated $370M liquidation preference, it's mathematically consistent that founders received minimal to no upfront proceeds. Future compensation may come through the earnout structure, which typically pays out based on achieving specific business milestones or performance metrics post-acquisition.

Reports of a "cram down" financing round prior to acquisition suggest a restructuring of the cap table that likely reduced the effective liquidation preference below $370M, as non-participating investors' shares would have been significantly diluted or eliminated. However, without access to the specific terms of this round or the final cap table structure, the exact impact on founder proceeds cannot be definitively calculated.

The structural challenges that led to this outcome are primarily driven by the company's financial position. With high burn rates, decelerating growth, and significant capital obligations, Truepill likely became an unattractive investment prospect. The M&A offer, despite being suboptimal for the founder, may have represented the best available exit path given these constraints.

This raises an important structural question about startup financing: Would eliminating share class distinctions and complex preferences (like liquidation preferences) create healthier outcomes? Under a single-class structure, early investors could potentially maintain their ownership positions and realize returns more proportional to their early risk-taking. This might have produced a different outcome for Truepill, where early investors and founders could have participated more equitably in the exit proceeds rather than being subordinated through preference structures or diluted through pay-to-play provisions.

However, this would require a fundamental shift in venture capital dynamics, as preferred shares and liquidation preferences are key risk-mitigation tools that help attract growth capital.

A more detailed analysis of this growth trajectory reveals several key factors that contributed to the dilutive impact:

The company underwent significant operational expansion and leadership changes, including:

• Five financing rounds versus the initial one

• Three different CEOs, each likely requiring substantial equity compensation

• Five different management teams, all requiring competitive equity packages

• Workforce expansion from 30 to 500 employees, necessitating a larger option pool

Each of these transitions introduced multiple layers of dilution. The sequential financing rounds each brought new preference stacks and ownership dilution. Multiple CEO transitions typically require significant equity grants to attract top talent, while successive management teams and substantial employee growth further expanded the equity distribution. The cumulative effect of these changes—multiple rounds of financing preferences combined with extensive equity compensation across leadership and employees—dramatically reduced the founder's effective ownership and position in the liquidation stack.

So what should you make of this? 

The relationship between capital raised and founder returns requires careful consideration. Each dollar of outside investment typically needs to be repaid through liquidation preferences before founders receive distributions in an M&A event. This creates a significant hurdle to founder returns, amplified by additional financial instruments like debt or enhanced preferences. While capital-intensive businesses like Uber may require substantial funding, even a $500M exit could result in minimal founder returns if the company has raised $1B, highlighting the importance of capital efficiency.

From an investor's perspective, the liquidation preference stack creates its own challenges. When evaluating companies with significant existing preferences, the risk-reward profile becomes increasingly unfavorable. The company must generate returns well above the current preference stack to provide meaningful upside, while risks like down rounds, suboptimal M&A outcomes, or founder burnout remain significant threats to returns.

This dynamic has influenced our decision to bootstrap rather than raise outside capital. A $50M exit as a bootstrapped company could potentially generate similar founder returns to a venture-backed $250M exit, where returns are diminished by multiple rounds of dilution, option pools, and potential debt obligations. This capital-efficient approach preserves both ownership and flexibility in future exit scenarios.

If you enjoyed reading this article, feel free to view our prior articles on deal structures and terms: 

• The Pro-Rata Trap: How VCs Lose Millions on Their Biggest Winners

• Breaking Down the Secondary Transaction in Venture Capital

• VC Uncapped Rounds - Invest or Avoid Completely?

• Pay to Play Rounds - The Bane of the SPV

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Sydecar empowers syndicate leads to manage their investments more effectively. Organize, manage, and engage your investor network effortlessly with Sydecar’s management and communication tools. Their platform also automates banking, compliance, contracts, tax, and reporting, freeing up syndicate leads to focus on securing deals and strengthening investor relations. Elevate your syndicate operations with Sydecar.

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✍️ Written by Zachary and Alex