I recently answered a question on Quora that basically came down to that headline: Is it a good idea for an angel investor to make their investment impossible to dilute? Why or why not?

The actual question was this: “What clause in termsheet can allow an angel investor to hold on to his shares in a startup even till the stage of IPO without there being a compulsion on him to dilute or cash out? Is there any clause like that at all?”

This was my answer:

You can write a legal clause in an investment agreement to do anything you want, but there are good reasons to be careful with anti-dilution clauses that will hinder or make it impossible for the company to raise future investment rounds.

Basically, a startup with angel investors it cannot dilute is a dead startup. If you find a startup founding team that is willing to give you a magical “anti-dilution forever” clause, run away and invest elsewhere.

There is a reason that you almost never see these kinds of clauses, except maybe in very small, closely held family businesses who expect to raise only a single round of capital: They prevent future investment.

Follow-on venture capital and private equity investors who want to put big money into a growing startup need to be able to negotiate and set investment terms with the business that make sense for both the investor and the business.

For a typical, new equity investment, that always involves some amount of dilution of prior shareholders in terms of overall ownership. If those existing shareholders cannot be diluted, then the company is unlikely to be able to raise additional capital.

However, keep in mind that follow-on investment under new terms and the accompanying dilution of prior shareholders is almost always a good thing: After a new investment round, earlier investors may own a smaller percentage of the company, but the shares they do own are suddenly worth a lot more. The pie gets bigger and every shareholder benefits. This is by design and is called “accretion.” Gaining this boost in share price is usually the main goal of the original angel investment.

Only a very poorly designed investment round will result in an earlier investor having shares worth less than they were before the round. This does sometimes happen if a company becomes distressed and needs to raise money at any price. It is called a “down round,” when shares are sold at a lower price than they were in a prior investment round.

There are common legal clauses that can help to protect angel investors from future down rounds. This is usually done by diluting the equity of the founder’s shares rather than the early angel investor, so that the founders are punished and the angel investors are protected. As you can probably imagine, this is a very risky tactic. It can completely demoralize a company and lead to the founders exiting the company, but it is a more common tactic than trying to prevent all future dilution.

Strong anti-dilution clauses for early angel investors? Sure, you could do it, but you shouldn’t if you have any hope for the company.

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Kraettli Lawrence Epperson

Managing Director at JumpPhase Ventures

This blog is dedicated to providing advice, tools and encouragement from one entrepreneur to another. I want to keep this practical and accessible for the new entrepreneur while also providing enough sophistication and depth to prove useful to the successful serial entrepreneur. My target rests somewhere between the garage and the board room, where the work gets done and the hockey stick emerges.

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