Fundraising Terms: Anti-Diltuion Provision (Part 2)

Hello Founder, 

In our last post, we kicked off discussing the anti-dilution provision clause.

Here’s a quick reminder of what we discussed:

The price-based anti-dilution clause provides a protection mechanism that will be triggered whenever the company issues additional equity securities (shares or instruments convertible into shares) at a price that is lower than the price paid for the shares by the investors. The anti-dilution protection is an agreed right attached to the preferred shares and serves as an advantage for the preferred shareholders (Series [X] investors) over the common shareholders (founders, employees, etc.), who will pay the price for the dilution.

When anti-dilution protection is triggered, the protected investors obtain the right to receive additional shares. This right may be exercised by either of two mechanisms: (a) by adjusting the conversion ratio of the preferred shares into common shares, or (b) by directly issuing additional shares to the investors. 

There are two basic types of price-based anti-dilution protection: (a) full ratchet anti-dilution protection and (b) weighted average anti-dilution protection.

Under the full ratchet protection, the investors will be put in the position as if they had invested at the new, lower issue price, that is, the earlier round price is effectively reduced to the price of the new issuance, completely preserving the value of their initial investment in a down round and diluting all existing common shareholders. 

In today’s post, we will be discussing the second type of anti-dilution protection—weighted average anti-dilution protection.

In contrast to the full ratchet protection, the weighted average anti-dilution protection takes into account the proportional relevance of the subscription price paid in the down round and the subscription price paid in the previous round. As in the full ratchet mechanism, it takes a new share price based on which the investors will be compensated. However, it will not bring the old price down to the new price of the down round but will bring it down to a new price (weighted average price) determined by the average of both prices, after they are weighted. 

For the new price, the weighting factor is the number of shares issued in the down round. 

For the old price, the factor is one of these two options: 

(i) (broad-based weighted average) the total number of common shares outstanding prior to the dilutive financing round on an ‘as-if converted and fully diluted’ basis. A broad-based weighted average provision encompasses both the company’s common stock outstanding (including all common stock issuable upon conversion of its preferred stock) as well as the number of shares of common stock that could be obtained by converting all other options, rights, and securities (including employee options).  

(ii) (narrow-based weighted average) part of the shares outstanding prior to the dilutive financing round as specified in the term sheet. A narrow-based provision will not include other convertible securities and will limit the calculation to only currently outstanding securities.

The narrower the base, the larger the effect of the new price and the more favourable the clause is to the protected investors.

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To calculate the weighted average price, parties include a mathematical formula in their shareholders’ agreement. Though each formula may look alike, the definition of Q1 may strongly vary. As explained above, protection based on either of the two averages depends on the definition of Q1.

Weighted Average Price =  [(P1*Q1) + (P2*Q2)]/Q1+Q2

where

P1 = the subscription price in the previous round i.e. the round before the down round;

P2 = the subscription price in the new round i.e. the down round;

Q1 = broad-based: the total number of shares outstanding prior to the down round, on an ‘as-if converted and fully diluted’ basis; OR ‘narrow based’: part of the shares outstanding prior to the down round as specified in the term sheet;

Q2 = the number of shares issued in the new round.

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Let’s use an example to see how this works.

Company Z is looking to raise a $1 million Series B round at a valuation 50% lower than its valuation in the Series A round.

 Key Parameters:

Shareholder | Number of shares | % Ownership

- Common shareholders (founders, employees, etc.) | 800,000 shares | 80%

- Series A preferred shareholders (with broad-based weighted average anti-dilution clause) | 200,000 shares | 20%

- TOTAL | 1,000,000 shares | 100%

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Price per share

- Series A: $2/share

- Series B: $1/share

- Series B Investment amount: $1,000,000

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Let’s recall our formula:

Weighted average price = [(P1*Q1) + (P2*Q2)]/Q1+Q2

Based on these parameters, let’s calculate the variables in our formula

P1 = $2

P2 = $1

Q1 (broad-based) = 1,000,000 shares

Q2 = (Series B investment amount)/(Series B price per share) = $1,000,000/$1 = 1,000,000 shares

WAP = [(2*1,000,000)+(1*1,000,000)] / (1,000,00+1,000,000)

= [2,000,000 + 1,000,000] / (2,000,000)

= [3,000,000] / (2,000,000)

= $1.5 

$1.5 is the new price per share at which the protected shares of Series A will convert. That is, the price per share will reduce from $2 per share to $1.5 per share. Their 200,000 shares will increase due to the reduction in the share price. The formula is as follows:

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New number of shares = Old number of shares * (Old price per share/New price per share)

= 200,000 * ($2/$1.5)

= 200,000 * 1.33

≈ 266,667  shares

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Please note that this weighted average price only applies to existing investors with the anti-dilution protection and doesn’t apply to the new investors in the down round.

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A term sheet would typically state that weighted average protection is applicable, without including a formula or indicating whether a broad-based or narrow-based weighted average is to be applied. In view of the different levels of anti-dilution protection provided by each particular weighted average formula, the formula and its contents should ideally be a part of the discussion during the term sheet negotiations.

In some situations, full ratchet anti-dilution can convert to the weighted average. For example, a time limit can be placed on the full ratchet anti-dilution right, i.e. after a certain period, the full ratchet anti-dilution protection switches to a weighted average formula or is forfeited altogether. The following clause contains such a limitation:

In the event that the Company issues equity securities prior to [date] at a purchase price less than the applicable conversion/subscription price of the Series [X] Shares, then the conversion price of the Series [X] Shares will be subject to a [full ratchet / weighted average] adjustment.

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A share price floor may also be included. If the new share price in the down round falls below a specific price, the full ratchet protection switches to a weighted average anti-dilution protection. An example of such a clause in a term sheet is the following:

In the event that the Company issues equity securities at a purchase price (the ”Purchase Price”) less than the applicable conversion price of the Series [X] Shares, then the conversion/subscription price of the Series [X] Shares will be subject to (i) a full ratchet adjustment if the Purchase Price is greater than $[___] per share; and (ii) a weighted average adjustment if the Purchase Price is less than $[___] per share.

Carve-Outs and Adjustments

Not every issuance of shares below the original purchase price, however, should trigger anti-dilution protection. The most obvious exception is the issue of common shares upon conversion of the preferred shares. Another typical exception set out in term sheets is the issue of shares or options at a discount to employees under an employee stock option plan (ESOP).

Other, less obvious, carve-outs should be judged by the investors or the Supervisory Board on the basis of individual cases. Examples are common shares issued or issuable in connection with:

- A merger or acquisition of the Company;

- Any borrowings from a commercial lending institution;

- A public offering before or in connection with which all outstanding preferred shares will be converted to common shares or upon exercise of warrants or rights granted to underwriters in connection with such a public offering.

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Anti-dilution provisions are almost always part of the financing, so understanding the nuances and knowing which aspects to negotiate are an important part of the entrepreneur’s toolkit. Do not get hung up trying to eliminate anti-dilution provisions. Instead, focus on minimizing their impact and building value in your company after the financing so they don’t ever come into play.

We hope this 2-part post has been insightful. 

Till you read from us again, keep building the future of Africa!