Look for Notice: For Stock or Options, an Anti-Dilution Clause Alone Isn’t Enough
When receiving or granting stock or options in a fledgling situation, you should not only look for an anti-dilution clause, but also check to be sure a requirement of notice is included.
Many startup companies offer compensation to founding members and original employees in the form of equity in the company. This can be beneficial to all the parties involved. For the fledgling company the stock or option is a cheap way of retaining talent. Further, it motivates the talent to perform to increase the value of their compensation.
Notice Is Often Overlooked
When a company is in the early rounds of granting stock or options, it has to decide whether or not the equity they are granting can be diluted. (This decision is a complicated one, and will be addressed in a future post.) If a company and the stock or option receiver together agree to prevent dilution, there is an often-overlooked requirement that notice be given to the stock or option holder of any event in which dilution will occur.
Notice is an important component of any anti-dilution clause, as many stock or option holders are no longer involved in the company by the time a dilution occurs, and may not otherwise be aware of the dilute event. Notice allows the share or option holder to understand his or her position as a dilution event triggers the anti-dilution clause.
The requirement of notice is beneficial for the company as well. In the event of a dilution, if the shareholder or option holder does not agree and believes it to be a breach, notice of the company’s intended action can be seen to start the clock running on the statute of limitations.
An Example of Anti-Dilution and Notice Benefits
Imagine you hire a CEO for the first year of operating your company. As a part of her compensation package you offer her 20% of the company’s outstanding shares. Further, your agreement contains an anti-dilution clause. A year after the CEO has left the company, it takes on new financing. This typically would trigger the anti-dilution clause. If, five years later, the company has a liquidation event, thinking it has diluted the CEO’s 20% to some much smaller number, the CEO may well bring suit for the full 20%. However, if notice of the dilution was given, the CEO would have been obligated to assert her rights at that time. This would give the company and the CEO the ability to deal with the problem long before the liquidation event, and can prevent the possibility of litigation.
Simple Anti-Dilution Notice Solution
A simple phrase included in your agreement, such “any event triggering this clause requires notice to be given to the shareholder/option holder,” can potentially prevent problems and litigation surrounding future dilution events.
If you are interested in having me review your stock or option agreement to discuss issues surrounding anti-dilution and notice, please contact me.