UNDERSTANDING ANTI-DILUTION PROVISIONS
Dilution and anti-dilution—on their face and in a cocktail party conversation—are pretty simple concepts. But, the application can be nuanced and complicated. Or, at least, kinda boring. However, they are extremely important. In the world of venture capital and startup funding, preferred stock is a common investment instrument used to attract investors and provide them with certain privileges. One critical aspect of preferred stock is the inclusion of anti-dilution provisions, which protect investors from potential value erosion caused by subsequent equity issuances. In this blog, we will delve into the different mechanisms for anti-dilution provisions in preferred stock, shedding light on how they function and the protection they offer to investors.
I have been advising startups and investors in venture capital transactions and angel financing investments for over 20 years, guiding and counseling clients through the process, negotiating on their behalf, protecting their rights, and ensuring clarity and understanding of an otherwise stressful process. Read more about my Corporate Finance practice here.
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First, What Is Dilution?
Dilution, in the context of corporate capitalization, refers to the reduction in the ownership percentage or economic value of existing shareholders' equity when additional shares of stock are issued. In the context of a preferred stock deal, dilution occurs when a company raises capital by issuing additional shares of stock, such as common stock, at a lower price per share than what existing shareholders initially paid. As a result, the relative ownership stakes of existing shareholders are diluted, meaning their percentage of ownership in the company decreases. Dilution can have a direct impact on the voting rights, control, and financial interests of shareholders. Anti-dilution provisions are often employed to protect shareholders from excessive dilution and ensure a fair distribution of ownership and value as the company grows and raises additional capital.
So, What Is Anti-Dilution?
In a convertible preferred stock deal, the term "anti-dilution" refers to a set of provisions designed to protect the rights and economic value of existing investors who own preferred stock if there is a "down round" later on. A down round is a later financing round in which additional shares of common stock are issued at a price per share less than the current conversion price ("CP") of the existing preferred shares. These provisions are a remedy to existing preferred investors against the full dilution they would otherwise suffer as a result of the down round. Anti-dilution provisions mitigate the dilutive impact on these existing investors by retroactively lowering the CP of their preferred shares automatically when these additional shares are issued. Think of this as a sort-of compensation to the existing preferred investors for any decrease in the value of their investment in a down round, helping them to maintain their proportional ownership stakes, and providing them with a fair share of the company's value. By incorporating anti-dilution mechanisms into preferred stock deals, both investors and companies can strike a balance between attracting new capital and preserving the interests of existing shareholders. Below, we will explore different types of anti-dilution mechanisms.
➡ Full Ratchet Anti-Dilution
Full ratchet anti-dilution is the most investor-friendly (founder-hostile) anti-dilution mechanism. Full ratchet anti-dilution reduces the CP to the lowest price at which any additional common shares are issued in the down round, regardless of the number of shares sold. Naturally, this mechanism offers robust protection for investors by allowing them to convert their preferred stock into a greater number of common shares at this newly lowered conversion price, allowing them to maximally preserve their ownership percentage and economic value. However, this preservation can come at the expense of founders and other early investors who may themselves suffer substantial dilution as a result of the full ratchet mechanism which does not benefit them. Although the concept behind full ratchet anti-dilution—maintaining the economic value of the protected investor's investment—is straightforward, the other side of the coin is that full ratchet can have significant, negative implications for these founders and other shareholders. This can act as a deterrent for entrepreneurs seeking additional financing rounds, as the full-ratchet CP adjustment can not only reduce ownership stakes for founders and these other shareholders, but can also impact (negatively) the ability to attract new investors or negotiate favorable terms in subsequent funding rounds. For these reasons, full-ratchet anti-dilution provisions are not common in convertible preferred stock deals compared to "weighted average" provisions.
➡ Weighted Average Anti-Dilution (Broad Based)
Broad-based, weighted average anti-dilution is the most commonly used mechanism for protecting investors from dilution in convertible preferred stock deals. The goal of broad-based, weighted average anti-dilution is to strike a balance between protecting the investor from dilution and acknowledging the company's need for future financing. As with full ratchet, the weighted average mechanism adjusts the CP of existing preferred stock to reflect the impact of a down round. However, the weighted-average calculus takes into account the weighted average price and quantity of new shares. (Remember, that full ratchet adjusts the CP to the lowest price at which additional common shares are issued no matter the number of shares sold.) Weighted average provisions, therefore, protect preferred stock investors in a down round, but in a way that balances the positions of founders and other early investors. The calculation for the CP adjustment under weighted average anti-dilution is based on a formula (which is included in the Certificate of Incorporation). The formula takes into account the number of outstanding shares before the new issuance, the price per share in the new issuance, and the average price per share paid by the investor. The goal is to proportionally reduce the CP to compensate for the dilution caused by the subsequent financing round. The formula for calculating weighted average anti-dilution is commonly expressed in a way similar to the following:
CPN = CPO multiplied by the quantity [(A + B) ÷ (A + C)]
Where:
CPN = New conversion price of the preferred stock (resulting from this formula)
CPO = Original conversion price of the preferred stock (immediately before this adjustment)
A = Number of shares outstanding before the issuance of new shares in the down round
B = Number of new shares that would have been issued if sold for a per share price = the CPN
C = Number of shares of stock actually issued in the down round
In the broad based weighted average formula, "A" is typically the number of fully diluted common shares ... that is, the common shares both actually outstanding, plus common shares that are issuable but not yet outstanding at that time. In other words, for purposes of this calculation, outstanding options, warrants, convertible preferred stock, and other securities that are convertible into or exchangeable for common stock are counted as though their underlying common shares had been issued (but not counting any securities converting in the down round itself).
Weighted average anti-dilution provisions are often favored by investors due to their equitable nature. They provide protection without imposing disproportionate consequences on other shareholders or potential deterrents to future fundraising efforts. This mechanism strikes a balance between protecting investors' interests and allowing the company to attract new investors and raise capital at a reasonable valuation.
➡ Weighted Average Anti-Dilution (Narrow-Based)
Narrow-based weighted average anti-dilution provisions acknowledge that not all dilutive events have the same impact on the existing preferred stockholders. In the narrow-based weighted average approach, the formula for calculating the adjustment is similar to the broad-based formula, with one key difference. In the formula, the value of "A"—which represents the number of shares outstanding before the issuance of new shares—is narrowed to exclude certain reserved but unissued shares. In this context, "A" would encompass all currently outstanding shares of common stock, plus all shares of common stock into which the currently outstanding preferred shares would be converted if converted on that date. However, other common shares that have been reserved for later issuance but which have not been issued yet (such as those reserved for employee stock options and restricted stock units (RSU's), convertible notes, and/or other forms of securities not directly contributing to dilution for existing preferred stockholders) are excluded from the calculation. (Remember that in the broad-based formula, all of these reserved shares are included in the calculus.)
The exclusion of these reserved, unissued shares in the narrow-based weighted average anti-dilution provision acknowledges that these shares do not directly contribute to the dilution of the existing preferred stockholders. By excluding events that may not significantly impact the ownership percentages of existing preferred stockholders, this provision seeks to mitigate the potential dilution concerns raised by other shareholders. The inclusion of a narrow-based approach allows companies to strike a compromise that protects investor rights while providing flexibility for future fundraising. It addresses concerns that excessive dilution caused by certain types of issuances could discourage future investments or disincentivize key stakeholders. This provision can help preserve the balance between the interests of investors and the company's ability to attract and retain talent.
➡ Pay-to-Play Anti-Dilution
Pay-to-play anti-dilution is a provision in investment agreements that incentivizes existing investors to maintain their financial support for a company during subsequent financing rounds. Under this mechanism, if an existing investor chooses not to participate in a new financing round, they may face a penalty in the form of additional dilution of their ownership stake. The pay-to-play provision ensures that investors who continue to support the company by investing in subsequent rounds are protected from excessive dilution, while those who opt not to participate may experience a more significant reduction in their ownership percentage. This provision encourages ongoing financial commitment from investors and helps maintain the company's stability and attractiveness to potential new investors.
TAKEAWAY
Anti-dilution provisions in preferred stock play a crucial role in safeguarding investor interests in the complex world of startup investments. By understanding the different mechanisms for anti-dilution provisions, such as weighted average, full ratchet, narrow-based weighted average, and pay-to-play, investors can negotiate terms that strike a balance between protection and the company's need for future fundraising. These provisions ensure that investors are not unfairly diluted, while also considering the long-term sustainability and growth of the business. Consulting with experienced business legal counsel is crucial for both investors and entrepreneurs to navigate the complexities of anti-dilution provisions and negotiate fair and favorable terms that foster trust and collaboration between all parties involved.
Be Proactive About Being Protective
Venture capital financing deals include many complex provisions and numerous possibilities in negotiation. If you are considering investing in a venture capital round or your company is seeking venture capital financing, it is recommended to consult with an experienced corporate and securities attorney. Contact an experienced corporate lawyer / securities attorney if you have been presented with a term sheet, or are contemplating negotiating a venture capital financing transaction. Make an appointment now for a free consultation.
A.I.
I have become very impressed with the efficiency possibilities of AI. So, I gave ChatGPT a try. I generated this text in part with GPT-3, OpenAI's large-scale language-generation model. After it generated its own draft language, I reviewed, edited, revised, and expanded on it to my own liking and to ensure accuracy in all material respects. WLF takes ultimate responsibility for the content of this article.
Disclaimer
This article is not legal advice, but is provided for general information purposes only: see the disclaimer in the footer of this site, and read my Legal Notices here.