Anti Dilution Measures
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The contractual terms (referred to as anti dilution measures) VC investors use to protect against dilution within down rounds.
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Glossary
Anti-DilutionTranscript
Anti-dilution provisions are mechanisms that protect certain VC investors from the dilutive effect that comes from future stock issuances.
The most common protections are designed to apply in down round situations where the company's value has fallen since the previous capital round took place. There are two types of anti-dilution measure to consider. The first is a price-based anti-dilution provision, and the second is the contractual anti-dilution adjustment.
To implement a price-based anti-dilution measure, the company's charter includes a mechanism to automatically adjust the rate at which preferred stock converts to common stock. If the company has a down round, usually preferred stock converts to common stock at a one-to-one ratio. This conversion ratio is important as it affects relative voting rights. How proceeds in a company sale will be allocated among stockholders and the number of shares that investors will hold after an IPO when the preferred stock converts to common stock.
There are two methods for adjusting the conversion ratio. A weighted average adjustment involves a formula that compares the number of shares that would've been issued to the new investors if they had paid the same price as the earlier investors against the number of shares issued to the new investors at the lower price. There are two ways in which the weighted average adjustment can be calculated. The broad based weighted average formula is commonly used and incorporates the fully diluted capitalization of the company, which lessens the dilution impact on the common stockholders. Sometimes the formula may only include outstanding shares, excluding shares that have yet to be issued through stock options referred to as a narrow based weighted average formula, which is more favorable to the investors. The other option is a full ratchet adjustment, which lowers the effective perching price of the protected stock to the actual price paid in the down round. Regardless of how much capital is raised or how much equity is issued with the new down round, a full ratchet provision will always result in a larger conversion rate adjustment and a weighted average provision. And for that reason is more detrimental to founders and other common stockholders, and it can potentially cause founders to lose their majority stake and control of their company. While most series A and later rounds include weighted average anti-dilution provision. Earlier seed financings may or may not include that provision and full ratchet provisions are not commonly used. Also, certain stock issuances are excluded from the anti-dilution mechanism, such as options issued to employees or advisors or warrants issued in connection with a line of credit. Now, let's walk through how to calculate the adjusted conversion ratio to apply against the new down round financing. The formula is calculated as follows. The conversion price will be equal to the prior conversion price multiplied by A plus B, where A is the number of shares issued prior to the new down round, and B is the total investment in the new down round divided by the prior conversion price.
That is all then divided by A plus C, where A is again, the number of shares outstanding prior to the new down round plus C, which is the number of shares issued in the new down round. So what can we learn from these provisions? From the founder's perspective, they and all common shareholders are diluted in all three down round scenarios, but of the three pricing options, the broad, broad-based weighted average price provides better protection for the founders and other common shareholders. The largest dilution comes under the full ratchet price option. The best option for founders is that there is no anti-dilution protection, but broad-based weighted average is still a much better option than a full ratchet while still protecting earlier investors.
For Series A investors, they are diluted only under the first and second option and a much lower percentage dilution than the founders. The full ratchet pricing option is better for the series A investors than the founders and other common shareholders.
A second anti-dilution measure is rarely used, but referred to as the contractual anti-dilution adjustment.
This is basically a contractual agreement between the founders and certain investors where the investors have the right to receive for no additional payment, sufficient shares of common stock necessary to protect them from dilution of their percentage interest in the company as a result of new share issuances, regardless of the price at which the new shares are sold. If this type of agreement were in place for early stage angel investors, it would likely need to be terminated before any VC investors agreed to invest in the company.