Venture capital investors invest in startups in the hopes that later rounds of investment will increase the company’ valuation. As more investors invest, the percentage of the company that each investor owns decreases, an effect called dilution.In any investment negotiation, some of the most critical decisions are about provisions that protect investors from dilution in subsequent financing rounds. Click To Tweet
As important as avoiding dilution is for an investor, specific provisions can impact on founder and employee ownership unfavorably.
Why do investors ask for anti-dilution provisions?
As long as subsequent investors invest at a higher price per share, the overall dollar value of the previous investments increases, even if their percent ownership decreases.
But what if shares sold in later rounds of investment are sold at a lower price per share? In such a down round scenario, the earlier investors have a decrease in ownership and a reduction in the value of their investment.
Investors do their best to avoid the down round scenario when a private company offers additional shares for sale at a lower price than had been sold for in the previous financing round. If more capital is needed, the company discovers that its valuation is lower than it was before the previous round of financing, forcing founders to sell their capital stock at a lower price per share.
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 avoid being hit by such a double-whammy, venture capital investors typically negotiate an anti-dilution provision clause in the company’s Amended and Restated Certificate of Incorporation filed with the financing round.
What are the most common anti-dilution provisions?
Both investors and founders must understand what protection each type of anti-dilution provision provides to make informed decisions during the financing negotiation process.
Three anti-dilution provisions are most commonly used to set the adjusted conversion price:
- Full ratchet
- Narrow-based weighted average, and
- Broad-based weighted average.
Full ratchet anti-dilution is the most protective for investors because the investor maintains the same percentage of ownership. This method does not use a formula, lowering the conversion price to the price paid in the down round. Because the earlier investors are converting their shares at the conversion price at which the company is now valued, the number of shares the earlier investor will receive will amount to the same ownership percentage of the company.
Under this method, all changes in ownership percentages are taken directly from the founders and other stockholders without this anti-dilution protection. It requires that early investors be compensated for any dilution in their ownership caused by future fundraising rounds.
Full ratchet provisions can be costly for founders and can undermine efforts to raise capital in future rounds of fundraising. That’s why weighted average approaches are a better alternative for founders than using the full ratchet provision.
Narrow-Based Weighted Average
The narrow-based weighted average method of anti-dilution, as the name suggests, narrows the base of shares used in the formula. This results in a lower conversion price and the investor gaining higher percent ownership. This provision ensures that investors aren’t penalized when companies issue new shares.
This narrow-based formula considers only the total number of outstanding preferred shares for determining the new, weighted-average price for the old shares.
It can be made more investor-friendly by narrowing the base only to represent the common stock issuable upon converting particular series of shares of preferred stock in question. Options, warrants, and shares that are issuable as part of stock incentive pools are typically excluded from the narrow-based weighted average.
This anti-dilution method is not as strict as full ratchet anti-dilution. The narrow-based weighted average is, therefore, better for investors than the founder-friendly broad-based anti-dilution approach.
Broad-Based Weighted Average
The broad-based weighted average anti-dilution provision is the best one for the founders. A broad-based weighted average for shareholders of a company’s preferred stock gives investors anti-dilution protection when a company issues new shares.
The conversion price of company stock is calculated using the broad-based formula and is higher than that calculated by the other two most common anti-dilution provisions. Since the conversion price is higher, the investment converts to fewer shares than a lower conversion price.
The value of the preferred shares will be adjusted to a new weighted average price using a calculation intended to protect investors from the dangers of share dilution.
The anti-dilution protection is less strict than under the other two anti-dilution provision types. This formula can be made even more company-friendly by including any shares reserved under the stock plan but not yet awarded.
Suppose a company has lost value but could recover with additional capital. In this case, founders may be extremely hesitant to seek financing in a down round if they will be losing a large amount of equity, even if it would benefit the company in the long run. Subsequent investors will want the same anti-dilution provisions as previous investors. Or, subsequent investors may hesitate to invest in a scenario where earlier investors have anti-dilution rights that may not leave enough equity to incentivize founders.
Understanding anti-dilution provisions will require understanding your cap table and doing math. It is important to note that negotiating such protections is a matter of leverage between the company and the investor. Both parties should consider the effect of such provisions on other investors and future investors.
José Padilla is an attorney and the owner of Padilla Law PLLC, where he represents startups and investors. His practice focuses on formation, seed and VC financings, private equity, acquisitions, strategic corporate transactions, and general advisory regarding corporate and financing strategy.
Featured image is of a stock market graphic by Markus Spiske on Unsplash.