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. This typically happens when a company seeks investment money, and issues stock in the company in exchange for capital. This is common in growth companies, and is known as financing "rounds". Consider the following example: NewCo receives $2 million at Series A with a pre-money value of $6 million. Combined, the founder shares and employee options pool total 6 million shares, so the investors receive 2 million shares of Preferred Stock, which is initially convertible to 2 million shares of Common Stock - a 25% equity stake. The conversion price is $1 per share. After the financing, NewCo has significant development and is valued at $20 million pre-money at Series B. The Series B Round will be a $10 million offering. An additional 1 million shares will be added to the pre-money capitalization and allocated to the employee options pool.
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. They will no longer own 25% of the fully diluted capital; they'll own (8 million / 13.5 million) of 25% to account for the new issuance of Series B Preferred Stock and options pool. They still have the right to convert their Preferred Stock (at $1 a share) to 2 million shares of Common Stock, but the company had to authorize additional stock for conversion in this transaction. The fully diluted capital of the company is now 13.5 million, rather than 8 million. The Series A investors can now convert to 14.8% ownership of the company. Their interest has been diluted from their initial 25% ownership, but the overall value of their investment has more than doubled, and they are generally happy. If, however, the new price of the stock devalued the company, a "dilutive financing" or "down round" would have occurred. If the same Series B were sold for $1.5 million, rather than $10 million, the new value of the company would be $4.5 million down from the initial $8 million, and the A round investor would only own 14.8%. As you can imagine, the investor is not as happy as they were in the above example. 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 4.5 milllion, and the price per share was $.01, then the B round investor would be contributing $1 million, and would now own more than 91% of the company. The A round investor's conversion rights to 2 million shares would now be worth $165,000. Definitely not happy. To account for natural devaluation of the company or intentional abuse, investors demand certain provisions be included in the amended charter (Articles of Incorporation or Certificate of Incorporation, depending on whether you are in CA or DE), as well as the Investor's Rights Agreement and other documents, resulting from a venture capital transaction. One of those provisions is the "Anti-Dilution Provision" and there are two well-known mechanisms: weighted average and full ratchet, though I rarely see the latter in term sheets. 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)
$/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 example where the company was worth $4.5 million, the Series A investor could convert to 14.8% of $4.5 million, or ~$665,000 - only 1/3 of their initial investment. Using a broad based weighted average, the conversion price would be ($1 * (8,000,000 + (1,500,000/1))/(8,000,000 + 4,500,000). That would be 9.5 million / 13.5 million, or $.7037. Rather than converting to 2 million shares of Common Stock, the Series A investor could convert their $2 million at $.7037 to 2.84 million shares of Common Stock. This is a disincentive for the company to engage in dilutive financing, because the founders will be diluted more. 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 * (2 million + 2 million)/(2 million + 4.5 million) OR $1 * 4/6.5 OR $.6153. Conversion would result in 3.25 millionshares of Common Stock. With a lower prior shares number, the difference in price weighs more in the formula, depressing the conversion price. Full Ratchet This provision allows the Series A investor to convert at the price per share of the offering. Since the Company issued 4.5 million shares for $1.5 million, the price per share was $.3333. The Series A investor can now convert their $2 million to 6 million shares. As you can see, the formula that provides the lower conversion price from the same transaction results in the greater benefit 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 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 for the founders running out of capital funds and to protect themselves from any dilutive financing that might devalue their investment in the company.
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