Venture capital investors invest in companies in the hopes that later rounds of investment will increase the valuation of the company. As more investors invest in a given company, the percentage of the company that each investor owns decreases, but as long as subsequent investors invest at a price per share that is higher, the overall dollar value of the previous investments increases, even if their percent ownership decreases.
But what if shares sold in later rounds of investment are sold at a lower price per share? In such a “down round” scenario, not only do the earlier investors have a decrease in ownership, but also a decrease in the value of their investment.
To prevent being hit by such a double-whammy, venture capital investors typically negotiate an anti-dilution provision to be included in the company’s Amended and Restated Certificate of Incorporation filed with the financing round.
Because preferred stock that investors buy include a right to convert into common stock, these anti-dilution provisions use an adjustment to the conversion price to mitigate both the decrease in ownership and the decrease in value that earlier investors face in the event of a down round. The anti-dilution provision lowers the conversion price upon a down round, so dividing the amount that the investor originally invested in the company by the lower conversion price will allow the investor to convert into more shares than previously entitled to (although the price per share will be less than at the original investment). Since share ownership must always total to no more than 100%, someone must absorb these changes to share ownership, and that someone will be all other existing stockholders without anti-dilution protection (e.g., founders, other previous investors).
There are different types of anti-dilution provisions that all provide varying degrees of protection against dilution. Because the more strictly an anti-dilution provision protects against dilution, the more it takes away from those without the provision, it is important that both investors and founders understand what protection each type of anti-dilution provision provides. Then, so each party can make informed decisions during the financing negotiation process.
There are three anti-dilution provisions that are most commonly used to set the adjusted conversion price: (1) broad-based weighted average, (2) narrow-based weighted average, and (3) full ratchet.
Broad-Based Weighted Average
The adjusted conversion price using a broad-based weighted average provision is set by the following formula:
CP2=CP1*((A+B)/(A+C)), where
CP2 is the conversion price after the down round,
CP1 is the conversion price before the down round (i.e., the price per share at which the investor bought its shares),
A is the fully-diluted capitalization prior to the down round (including the assumed exercise or conversion of all preferred stock, options and warrants),
B is the total consideration received in the down round of financing divided by CP1, and
C is the number of new shares issued in the down round of financing.
This anti-dilution provision is the best for the founders, as the conversion price calculated using the broad-based formula is higher than that calculated by the other two most common anti-dilution provisions. Since the conversion price is higher, the investment converts to less shares than a lower conversion price. So, the anti-dilution protection is less strict than under the other two anti-dilution provision types discussed here.
This formula can be made even more company-friendly by including any shares reserved under the stock plan but not yet awarded.
Narrow-Based Weighted Average
The narrow-based weighted average method of anti-dilution, as the name suggests, narrows the base of shares used in the formula which results in a lower conversion price and the investor having higher percent ownership. This method uses the same formula as is used above, except that “A” represents the outstanding common stock and as-converted preferred stock outstanding prior to the down round, excluding any reserved but unissued shares (e.g., options and warrants).
This narrow-based formula can be made more investor-friendly by narrowing even further so that “A” only represents the common stock issuable upon conversion of the particular series of shares of preferred stock in question.
This anti-dilution method is therefore better for investors than the broad-based anti-dilution and worse for founders but not as strict as full ratchet anti-dilution.
Full Ratchet
Full ratchet anti-dilution is the most protective for investors. This method does not use a formula at all and simply lowers the conversion price to the actual price paid in the down round. Because the earlier investors are converting their shares at the conversion price at which the company is now valued, the number of shares the earlier investor will receive will amount to the same ownership percentage of the company.
Under this method, all changes in ownership percentages are taken directly from the founders and other stockholders without this anti-dilution protection.
Conclusion
As demonstrated above, understanding anti-dilution provisions will require understanding your cap table and doing math. It is important to note that negotiating such protections is not only a matter of leverage between the company and the investor. Both parties should consider the effect of such provisions on other investors and/or future investors.
If a company has lost value but could recover with additional capital, founders may be extremely hesitant to seek financing in a down round if they will be losing a large amount of equity, even if it would benefit the company in the long run. Subsequent investors will want the same anti-dilution provisions as previous investors. Or subsequent investors may hesitate investing where earlier investors have anti-dilution rights that appear punitive or detrimental by not leaving enough equity to incentivize founders.
For any questions or want additional information, please do not hesitate to reach out to Padilla Law to help clarify your concerns.
Please note that this article (1) is not provided in the course of and does not create or constitute an attorney-client relationship, (2) is not intended as a solicitation, (3) is not intended to convey or constitute legal advice, and (4) is not a substitute for obtaining legal advice from a qualified attorney.