Venture capital investors invest in companies in\nthe hopes that later rounds of investment will increase the valuation of the\ncompany. As more investors invest in a given company, the percentage of the\ncompany that each investor owns decreases, but as long as subsequent investors\ninvest at a price per share that is higher, the overall dollar value of the previous\ninvestments increases, even if their percent ownership decreases. <\/p>\n\n\n\n
But what if shares sold in later rounds of investment are sold at a lower price per share? In such a \u201cdown round\u201d scenario, not only do the earlier investors have a decrease in ownership, but also a decrease in the value of their investment. <\/p>\n\n\n\n
To prevent being hit by such a double-whammy, venture capital investors typically negotiate an anti-dilution provision to be included in the company\u2019s Amended and Restated Certificate of Incorporation filed with the financing round. <\/p>\n\n\n\n
Because\npreferred stock that investors buy include a right to convert into common\nstock, these anti-dilution provisions use an adjustment to the conversion price\nto mitigate both the decrease in ownership and the decrease in value that\nearlier investors face in the event of a down round. The anti-dilution provision lowers the\nconversion price upon a down round, so dividing the amount that the investor\noriginally invested in the company by the lower conversion price will allow the\ninvestor to convert into more shares than previously entitled to (although the\nprice per share will be less than at the original investment). Since share ownership must always total to no\nmore than 100%, someone must absorb these changes to share ownership, and that\nsomeone will be all other existing stockholders without anti-dilution\nprotection (e.g., founders, other previous investors). <\/p>\n\n\n\n
There\nare different types of anti-dilution provisions that all provide varying\ndegrees of protection against dilution. \nBecause the more strictly an anti-dilution provision protects against\ndilution, the more it takes away from those without the provision, it is\nimportant that both investors and founders understand what protection each type\nof anti-dilution provision provides. Then, so each party can make informed\ndecisions during the financing negotiation process. <\/p>\n\n\n\n
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. <\/p>\n\n\n\n
Broad-Based Weighted Average<\/strong><\/p>\n\n\n\n The adjusted conversion price using a broad-based weighted average provision is set by the following formula: <\/p>\n\n\n\n CP2<\/sub>=CP1<\/sub>*((A+B)\/(A+C)),\nwhere <\/p>\n\n\n\n CP2<\/sub> is the conversion price after the\ndown round, <\/p>\n\n\n\n CP1<\/sub> is the conversion price before the\ndown round (i.e., the price per share at which the investor bought its shares),<\/p>\n\n\n\n A is the fully-diluted capitalization prior to\nthe down round (including the assumed exercise or conversion of all preferred\nstock, options and warrants), <\/p>\n\n\n\n B is the total consideration received in the down\nround of financing divided by CP1<\/sub>, and<\/p>\n\n\n\n C is the number of new shares issued in the down\nround of financing. <\/p>\n\n\n\n This\nanti-dilution provision is the best for the founders, as the conversion price\ncalculated using the broad-based formula is higher than that calculated by the\nother two most common anti-dilution provisions. Since the conversion price is higher,\nthe investment converts to less shares than a lower conversion price. So, the anti-dilution protection is less\nstrict than under the other two anti-dilution provision types discussed here. <\/p>\n\n\n\n This\nformula can be made even more company-friendly by including any shares reserved\nunder the stock plan but not yet awarded.<\/p>\n\n\n\n Narrow-Based Weighted Average<\/strong><\/p>\n\n\n\n The\nnarrow-based weighted average method of anti-dilution, as the name suggests,\nnarrows the base of shares used in the formula which results in a lower\nconversion price and the investor having higher percent ownership. This method uses the same formula as is used above,\nexcept that \u201cA\u201d represents the outstanding common stock and as-converted\npreferred stock outstanding prior to the down round, excluding any reserved but\nunissued shares (e.g., options and warrants). <\/p>\n\n\n\n This narrow-based formula can be made more investor-friendly by narrowing even further so that \u201cA\u201d only represents the common stock issuable upon conversion of the particular series of shares of preferred stock in question.<\/p>\n\n\n\n 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. <\/p>\n\n\n\n Full Ratchet<\/strong><\/p>\n\n\n\n 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. <\/p>\n\n\n\n Under this method, all changes in ownership percentages are taken directly from the founders and other stockholders without this anti-dilution protection. <\/p>\n\n\n\n Conclusion<\/strong><\/p>\n\n\n\n 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. <\/p>\n\n\n\n If a\ncompany has lost value but could recover with additional capital, founders may\nbe extremely hesitant to seek financing in a down round if they will be losing\na large amount of equity, even if it would benefit the company in the long run.\nSubsequent investors will want the same anti-dilution provisions as previous\ninvestors. Or subsequent investors may\nhesitate investing where earlier investors have anti-dilution rights that\nappear punitive or detrimental by not leaving enough equity to incentivize\nfounders.<\/p>\n\n\n\n For any questions or want additional information, please do not hesitate to reach out to Padilla Law to help clarify your concerns. <\/p>\n\n\n\n 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.<\/span><\/p>","protected":false},"excerpt":{"rendered":" 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 […]<\/p>","protected":false},"author":1,"featured_media":90,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[9],"tags":[],"yoast_head":"\n