Investors in startup companies generally require preferred shares in exchange for their investment. Preferred shares have numerous characteristics that protect the rights of the investor. One of the most prominent protection is anti-dilution. These provisions protect investors from losing value in their ownership interests if the company later sells additional ownership interests to investors at a lower price. It does this by adjusting the ratio at which the preferred shares convert into common shares. There are several types of anti-dilution protection.
What is Dilution of Ownership?
As explained, dilution occurs when an investor’s interest in a company diminishes in value because of a subsequent issuance of equity at a lower price than the investor paid for her shares. The lower-price issuance is commonly known as a “down round”. For example, assume ABC company authorizes 8 million shares. Investor A pays $2m for 2 million shares ($1.00 per share) equalling 25% ownership of ABC Company. The company is valued at $5m. The company does not perform very well. Later the company sells an additional 2 million shares for $1m ($.50 per share). Now there are 10 million shares outstanding. The investor’s ownership percentage is reduced or diluted. She now owns 20% of a company valued at $5m. This is called dilution of ownership.
What is a conversion ratio?
The preferred investor has the right (an often the obligation) to convert her preferred shares into common shares. The conversion ratio is generally 1-to-1 at issuance. This means that, if the price of shares is $1, her conversion price is $1. The conversion ratio is 1 to 1. Adjusting the conversion ratio can be used to maintain an investor’s value in the company through anti-dilution provisions. The idea is that the investor paid too much for the shares early in the company’s life. Allowing an adjustment in the conversion ratio allows her to maintain or recover the over-assessed value.
Types of Anti-Dilution
There are two major types of price-based anti-dilution measures — “full-ratchet” and “weighted-average” adjustments. Anti-dilution protection can include the following.
Full Ratchet Anti Dilution – This adjustment method provides 100% dilution protection to the investor. It does this by adjusting the conversion ratio so that the denominator is the price paid for stock in the later issuance. In the previous example, the price paid/conversion prices = 1, and is the conversion ratio. If the denominator is reduced to the price paid for the later equity ($.50), the ratio becomes 1/.5 = 2. So one share of preferred stock will convert into 2 shares of common stock. So, in the example, the investors 2 million shares will convert into 4 million common shares (40% of company ownership). 40% of a $5m company is $2m. This is the same as 25% of an $8m company. So, the investors interest is fully preserved after the later round of financing. These provisions are very onerous to common shareholders, such as the company’s founders. Increasing the percentage of ownership of the protected investor comes at the expense of existing common shareholder interest.
Weighted-Average Anti Dilution – This is a far more complicated adjustment method. It seeks to protect the investor without completely avoiding dilution. It bases the amount of investor dilution on the total number of new shares issued and the price of the issuance. The best way to explain the adjustment is to present the applicable formula.
CP2 = CP1 * (A+B) / (A+C), where:
CP2 = New Conversion Price
CP1 = the Original Conversion Price
A = the # of outstanding shares prior to the later issuance
B = the value received in new issuance, divided by the original conversion price (CP1)
C = the # of shares issued in the later issuance.
This formula may be a bit difficult to follow at first glance. Basically, it uses the value received in the new issuance as it relates to the initial conversion price. By dividing this by the number of shares in the later issuance, it provides a relative fraction to use for reducing how much existing shareholders are affected by the new issuance.
In our above example, the CP1 is 1/1 = 1. Prior to the issuance, there are 8 million outstanding shares (A). The value received from the new issuance is $1 million (B). The number of shares issued in the later issuance is 2 million (C).
CP2 = 1 * (8m + 1m) / (8m + 2m), so CP2 = 9/10 conversion ratio.
This anti-dilution adjustment comes in two forms. The first form is the broad-based adjustment. The second form is the narrow-based adjustment. A broad-based adjustment counts all outstanding shares, options, warrants, and other convertible securities). A narrow-based adjustment only uses the outstanding shares (not warrants, options, or convertible securities) to calculate the total outstanding shares. The broad-based formula provides the investor with greater protection.
LawTrades Knows Anti-Dilution
As you can tell from the above description, anti-dilution provisions can be complicated. Nonetheless, anti-dilution protection is an extremely important issue for investors. While many investors spend the majority of their time determining a reasonable value for the investment company, they cannot neglect the other provisions that will determine the possibility for a successful investment. The value that an investor attributes to a company and her willingness to invest will depend largely upon her comfort that her interest will not be eroded in later rounds of investment.
If you are going through an equity investment round. Let the professionals at LawTrades help. The team of legal experts at LawTrades can provide the professional guidance or services that you need to make your equity financing round a success.