Anti-Dilution Provisions in VC Transactions

Weighted Average (Broad/Narrow Based) & Full-Ratchet

Business Law Blog
Authored by Bryan Springmeyer
The information on this page should not be construed as legal advice.

I’ve noticed that a lot of the search terms that land people on this page are probably people who are interested in learning about minority shareholder dilution, so I’ve written an article discussing that issue along with other corporate transactions that can hurt minority shareholders. If you're interested in anti-dilution in venture capital deals, keep on going.

Anti-dilution provisions in venture capital transactions are protective clauses that prevent investors from unfairly losing ownership in a company. Dilution occurs when a company issues stock. Dilution is a natural occurence in growth companies, but dilution which devalues the investor's ownership is what these provisions seek to protect against.

Consider the following example:

NewCo receives $6 million at Series A with a pre-money value of $12 million. Combined, the founder shares and employee options pool total 9 million shares, so the investors receive 4.5 million shares of Preferred Stock, which is initially convertible to 4.5 million shares of Common Stock - a 33% equity stake. The conversion price is $1.3333 per share. At Series B, the investors value NewCo at $36 million. The Series B financing is $12 million. For purposes of this example, we'll assume no increase to the options pool occurs at Series B. We'll also assume that the Series A investors do not participate in Series B.

The Series A investors are happy, because the value of the company has gone up significantly. They'll be diluted by the Series B investment. The 4.5 million shares they own will no longer represent a 33% ownership stake, because the company's capital will be increasing from 13.5 million to 16.875 million (a 25% increase to accommodate the $12 million investment into a $36 million company). Rather, the 4.5 million will now represent a 26.67% ownership stake (4.5 million / 16.875 million). While that is a smaller proportion of the company, the overall value of their investment has gone from $6 million to $12.8 million (26.67% of the post-money Series B value of $48 million).

If, however, the new price of the stock devalued the company, a "dilutive financing" or "down round" would have occurred. If the same number of Series B shares were sold for $2.4 million, rather than $12 million, the new post-money value of the company would be $9.6 million (i.e., $7.2 million pre-money + $2.4 million) - down from the closing Series A value of $18 million, and the Series-A investor would only own 26.67%, effectively valuing their investment at $2.5 million. As you can imagine, the Series A investors would not be too happy with their investment value shrinking.

To take things to the extreme (of minority shareholder oppression and illegality) a dilutive financing can essentially devalue the prior investors of their investment in the company. If the new issuance of stock was for 100 million shares, rather than 3.375 milllion (the increase from 13.5 to 16.875 million), and the price per share was $.01, then the Series B investors would be contributing $1 million, and would now own more than 88% of the company, giving the company an effective pre-money value < $120,000. Ignoring other protections, the Series A investor's 4.5 million shares would represent < 4% ownership and effectively be worth < $45,000. Definitely not happy.

To account for natural devaluation of the company or intentional abuse, investors demand certain provisions be included in the amended charter (Certificate of Incorporation for Delaware corporations), as well as the Investor's Rights Agreement and other financing documents. One of those provisions is the "Anti-Dilution Provision" and there are two well-known mechanisms: weighted average and full ratchet, though the latter is not used much in conventional VC deals.

Weighted Average (Broad-based)

The following formula is used for weighted average:

New Conversion Price (post-issue) = Old conversion price * (Prior shares + $/Old)/(Prior shares + New shares)

New Conversion Price = New price at which the holder of Preferred stock will be able to convert into Common stock.  (This number will be lower, meaning that the Preferred stock holder will be able to convert to more shares, ensuring their ownership will not be unfairly diluted).

Old = Previous conversion price, pre-issue

Prior Shares = Number of shares of Common Stock outstanding prior to the new issue, including:

  • all shares of outstanding common stock,
  • all shares of outstanding preferred stock on an as-converted basis, and
  • all outstanding options on an as-exercised basis;

$/Old = Aggregate received for new issue divided by the previous conversion price (Old).

New shares = number of shares of stock issued in the subject transaction.

This protects the investor, because these dilutive financings bring down the conversion price. In the "not too happy" example above where the company's post-money value after Series A was $9.6 million, the Series A investor's Preferred Stock has lost 58.33% of the per share value. Using a broad based weighted average, the conversion price from Preferred Stock to Common Stock switches from an original price of $1.3333 to ($1.3333 * (13,500,000 + (2,400,000/1.3333))/(13,500,000 + 3,375,000). That would be $1.3333 *(15.3 million/16.875 million) or $1.20. Rather than converting the $6 million of Preferred Stock to 4.5 million shares of Common Stock, the Series A investor could convert their $6 million worth at $1.2089 to 4.96 million shares of Common Stock. This is a disincentive for the company (particularly the founders) to consummate a down round.

In a narrow-based weighted average, the above formula stays the same, but the "Prior shares" only includes the amount of common stock which is convertible from the subject class of preferred. Narrow based would be $1.3333 * (4.5 million + (2.4 million/1.3333))/(4.5 million + 3.375 million) OR $1.3333 * 6.3/7.785 OR $1.079. Conversion would result in 5.56 million shares of Common Stock. With a lower prior shares number, the difference in price weighs more in the formula, depressing the conversion price and resulting in more shares upon conversion.

Full Ratchet

This provision allows the Series A investor to convert at the price per share of the offering. Since the Company issued 3.375 million shares for $2.4 million, the price per share was $.7111. The Series A investor can now convert their $4.5 million to more than 6.3 million shares.

As you can see, the formula that provides the lower conversion price from the same transaction results in the greater protective treatment for the investor at the greater cost to the founders. One consideration is whether you really want to punish the company for dilutive financing. If the company has lost value over the course of development, and needs additional capital to continue, the investors might want the founders of the company to be able to acquire their capital needs without fear of losing a significant chunk of ownership. On the other hand, the investors want a deterrent against the founders running out of money and to protect themselves from any dilutive financing that might devalue their investment in the company.


Related Pages:
Minority Stockholder Oppression
Considerations in VC Transactions

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