During any investment, some of the integral parts of negotiations are provisions that protect investors from dilution in subsequent financing rounds. As important as provisions are to investors, they can also have an unfavorable impact on founder and employee ownership.
Table of Contents
- Why Are Anti-Dilution Provisions Important
- Types of Anti-Dilution Provisions
- Broad-based vs. Narrow-based Formula (and Which One is Better for Founders)
- How to Use Anti-Dilution Provisions in Ledgy
1. Why Are Anti-Dilution Provisions Important?
Investment rounds ideally increase the valuation of the company, meaning the pre-money valuation for each subsequent round is higher than the previous round. More rounds equals more investors, which means more people have to share the same pie. As long as the valuation of the company rises, investors usually don’t mind the decrease in ownership, because the increase in valuation raises the value of the stock they’re holding.
Let’s look at an example of an investor who owns 10% of a company valued at €5m. After additional financing rounds she ends up owning only 5% of the company. Nevertheless, now the company is valued at €25m, so the money she invested increased in value from €500,000 to €1,250,000.
However, in the event of a down-round, in which the company valuation decreases, investors like to be protected. Here’s an example of why investors want protection in the term sheet.
If you close a series A round of €1m at a pre-money valuation of €7m, the post-money valuation will be €8m (€7m + €1m = €8m). Let’s assume that the investor now owns 12.5% (€1m / €8m) of the company shares. If you later raise a series B round of €3m but can only get a pre-money valuation of €6m, the series A investor essentially lost 25% of the original investment.
Another reason why dilution matters to investors is in the voting power and control of the company. In most cases, control and voting power are tied to the amount and type of shares held by a given shareholder. Investors and even founders can find themselves outnumbered if their ownership in the company is diluted. To prevent this from happening, investors like to negotiate a clause called “Anti-Dilution Provisions”.
Last but not least, be aware that a very common and fair possibility is to have no anti-dilution protections at all. When we, at Ledgy, were raising our seed round, we did not use any anti-dilution protections in the contract. This means that the investors’ stock is treated similarly to common shareholders' stock and undergoes the same rate of dilution in the event of a down-round. From the founders and other common shareholders' perspective, this is a very fair option. However, if your investors require anti-dilution protection, continue reading to learn about the different types.
2. Types of Anti-Dilution Provisions
Usually, in a financing round, investors buy so-called “preferred stock”. It's called preferred because there is a special right attached to it – for example, liquidation preference. In the event of an exit, the holders of preferred stock will get their money back first. In case they choose not to use this right, they can simply convert their preferred stock to common via a conversion price.
Normally, the conversion price equals the price per share of the common stock from their round. For example, if they invested €1m when the price per share of common stock was €1, the investor would receive 1m shares. However, in the event of a down-round, this can change. Anti-dilution provisions protect investors by adjusting the price at which the investors’ preferred stock converts into common stock. This effectively increases the amount of common stock they are entitled to receive in the event of an exit. The most commonly used types of anti-dilution are full ratchet and weighted average (broad or narrow). The first is better for investors, the second is more founder-friendly.
In the case of a full ratchet anti-dilution, investors get to retain almost the same percentage of your company as before the down-round. For that to be possible, the conversion price for the investors’ preferred shares has to be adjusted.
For example, if investors in series A paid €2 per share and series B investors paid only €1 per share, the series A investors have the right to convert their shares at the new price of €1, given that they had full-ratchet protection. This means that each preferred share the series A investor holds now converts to 2 common shares, instead of only 1. Important to note here: the series A investor does not pay for these new shares he’s entitled to receive!
Even though many investors seek down-round protection, full ratchet isn’t very common in practice, and is only beneficial for the investor.
The next type is a little different. It’s not meant to recuperate all of early investors’ losses but rather to act as compensation. There are two ways of calculating it: “broad-based weighted average” and “narrow-based weighted average”.
We saw previously that in the full ratchet situation the conversion price equals the down-round’s conversion price, but here we have to calculate a different conversion price for existing investors. This is done with the same formula for both broad and narrow weighted average. The formula takes into account the number and the price of the new shares issued in the down-round.
Here, we are trying to calculate the new price per share that will compensate series A investors. We can expect the new price to be somewhere between the series A price and the price offered in the down-round. In this case between €2 and €1. This will result in the series A investors receiving more common shares as compensation.
Let’s assume a company has 1,000,000 common shares outstanding, and in their series A round, the company issues 1,000,000 shares of preferred stock for the price of €2 per share. The series A preferred stock is convertible to common stock at a 1:1 ratio, for a conversion price of €2. Thus, the total common stock outstanding before series B is 2,000,000. Then, in series B, the company issues another 1,000,000 shares at only €1 per share.
Now comes the time to calculate the new conversion price to compensate the series A investor.
To get the actual amount of common stock that the series A investors will ultimately hold, we have to multiply the number of shares they have from their round by the conversion rate caused by the down-round. The conversion rate is calculated by dividing the old conversion price (series A price) by the new conversion price.
The last step is to multiply the amount of shares the series A investor received in the series A round by the conversion rate. After converting his preferred shares to common shares, this will represent the number of common shares the series A investor owns.
The previous investor will be compensated for a down-round with additional common shares. In this case, 200,000 common shares.
3. Broad-Based vs Narrow-Based Formula (And Which One Is Better for Founders)
The difference between the two is in how the “common stock outstanding” part of the formula is calculated. We can already tell from the name that the broad-based weighted average is going to include a broader range of stock. Broad-based weighted average provision includes:
- The company’s common stock outstanding (this includes all common stock issuable upon conversion of its preferred stock)
- Common stock if all other options, rights, and securities were converted (including employee options), also called “fully diluted”.
Narrow-based weighted average includes only currently outstanding (not fully diluted) securities. What you probably want to know is: What kind of effect does each of these have on share allocation? Since the broad-based formula includes more shares in the CSO (common stock outstanding) part of the formula, this results in less anti-dilution compensation given (better for the founder). On the other hand, the narrow-based formula provides a greater amount of stock to be issued to holders of preferred stock, costing the founders more in terms of ownership.
For those of you, who’d like to test the difference between broad-based and narrow-based CSO count yourselves, try using numbers below in the first (NCP) formula and observe the result.
- Broad-based; CSO = 20,000,000
- Narrow-based; CSO = 2,000,000
NOTE: All stock amounts in the formulas are common shares and not preferred shares!
As written above, there are a couple of things to consider here, but perhaps the most important one has to do with the survival of the company. If the company lost value but needs additional funds to recover, do investors really want the founders to live in fear of losing a significant amount of ownership? All in all, the best option for founders is no anti-dilution protection, but weighted average is still a much better option than full ratchet, while still protecting early investors.
5. How to Use Anti-Dilution Provisions in Ledgy?
Here’s how you can include and track anti-dilution provisions with Ledgy. Create or edit a share class and assign it any of the above-mentioned options and click save. Now Ledgy will take this into account whenever you’re preparing for a new round.
Try the demo and see for yourself!
In the coming releases, we’ll even make it possible for you to model your financing rounds and exit with automatic anti-dilution calculation, and you’ll get to see the difference in “payout” based on terms in your term sheet!
- Woronoff, Michael and Rosen, Jonathan, "Understanding Anti-dilution Provisions in Convertible Securities" 74 Fordham Law Review,129 (2005)
- Colla, Derek. “What you need to know about down-round financings”. Cooley Go
- Riggs, Casey. “Venture Capital Term Sheet Negotiation — Part 7: Anti-dilution Provisions”, 8 March 2014, Strictly business law blog