Dilution prevention provisions are designed to protect the investor from dilution that may occur in subsequent financings where stock is sold at a price lower than the investor originally paid.
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What are Anti-Dilution Provisions?
Dilution prevention provisions are designed to protect the investor from dilution that may occur in subsequent financings where stock is sold at a price lower than the investor originally paid. The anti-dilution formula provides for an increase in the conversion rate of the preferred stock (and therefore a lower effective per share price on a common stock equivalent basis) in the event of a subsequent financing at a price less than that paid for the preferred stock being adjusted. A future financing sold at a price lower than in the prior round is called a “down round” or a “washout financing” (see the box at the end of the chapter discussing washout financings). Down rounds occur more frequently than you might think (approximately 20% of financings each year are down rounds). As a result, investors will generally insist on anti-dilution provisions to prevent dilution in the event of a future down round.
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What are the impacts on founders of anti-dilution provisions?
The question that entrepreneurs don’t always ask is: If the investors are protected from dilution in a down round, what happens to the rest of the company? Unfortunately, the common stockholders are the ones who will be impacted the most. Common stockholders are actually diluted twice in a down round – first the normal dilution from raising additional funds and then additional dilution to cover the dilution that occurred to the investors as a result of the anti-dilution provisions.
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Types of Anti-Dilution Provisions
While nearly all venture financings will include an anti-dilution provision, the primary point of negotiation will focus on the formula to use. In most venture financings, a weighted-average adjustment is a more common type of anti-dilution protection over the full-ratchet adjustment, which tends to have a more severe effect on the common shareholders.
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Types of Anti-Dilution Provisions: Weighted Average
Weighted average anti-dilution is not as severe as the full-ratchet anti-dilution provision discussed below. Instead of repricing the prior rounds at the same price of the down round, the weighted average dilution reduces the conversion price based on the investor’s ratio of stock owned to the total amount of stock of the company. Using this provision will decrease or limit dilution in a down round for the investor, but will not prevent it entirely.
There are two different types of weighted average calculations: broad-based and narrow-based, with broad-based being the more frequently used calculation. The primary difference between these terms lies in the way “common stock outstanding” or CSO is defined.
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Types of Anti-Dilution Provisions: Weighted Average -- Broad-Based
Under the broad-based provision, both (i) the current number of common stock outstanding (which would include the number of shares of common stock that would be issued in a full conversion of all preferred stock) and (ii) the number of shares of common stock that would be issued from the conversion of all options, stock rights, warrants, and other securities.
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