Terminology
financial terms : 5
Anti-Dilution:
Like pay to play provisions, anti-dilution provisions are put in place to preserve an early investor's equity and the value of their investment during a future down round of investments. These days it is increasingly common to find anti-dilution provisions tied to pay-to-play, where preferred investors who do not participate in future rounds waive their right to anti-dilution protection. Also note that typically, anti-dilution provisions do not issue out new shares to existing share holders, but they adjust the rate of conversion of a share of preferred stock to common stock. Let's start with an example: VCA invested $600,000 in Series A financing at $1/share in XYZ Inc to own 60% of XYZ Inc. Do note that the "shares" listed in the tables are on as converted basis to common stock.
During the Series B financing round, VCB invests $500,000 at $0.50 per share. The lower share price of XYZ Inc in the new financing round reduces the value of VCA investment by half to $300,000 along with a dilution of their equity from 60% ownership to 30% (refer table below). I mention the effect of down financing on % ownership by the investor because it will have ramifications for the investor in terms of special voting rights and seat on the board of XYZ Inc.
There are multiple flavors of anti-dilution and they can broadly be classified as ratchet based and weight based anti-dilution. Most common among ratchet based provisions is full ratchet anti-dilution. This provisions recalculates the conversion rate of the preferred shares of an investor to common stock such that the overall value of their investment is not diminished. I will elaborate with our existing case. VCA bought preferred shares in XYZ Inc at $1/share for a total of 600,000 shares. One share of Series A was equivalent to one share of common stock. In the next investment round, VCB invested $500,000 in the company at $0.50/share for a stock of Series B preferred, where one share of Series B converted to 1 share of common stock. If the conversion rate for Series A shares were to stay 1:1, it would mean that the value of Series A stock would be diminished to $0.50 per share. In order to preserve the value of VCA investment, the conversion rate of Series A to common is changed such that to one share of Series A converts to 2 of common stock. Not only does this method preserve the value of VCA investment in a down round, but it also increases the over all value of the company. Do note that while, the value of the investor investment is maintained, the equity owned by the founders undergoes a drastic devaluation (refer table below). Now the 600,000 Series A shares will convert to 1,200,000 shares of common stock with their valuation preserved at $600,000, making VCA the largest stock holder of XYZ Inc.
Do note, shares and ownership in the tables below is as converted to common stock
Without Anti-dilution
Full Ratchet Anti-dilution
In the last scenario we saw the Series B investor setting terms where the investment was pegged to a specific value per share. Alternatively an investor may negotiate for a specific level of ownership in the company for their investment. Lets look at another scenario (refer tables and diagrams below). VCA made a $500,000 Series A investment in XYZ Inc at $1/share where they own 50% of the company and the founders own the remainder (common stock). During a very weak investment period, they get VCB to invest $600,000 for a minimum of 50% of the company post deal. A full ratchet anti-dilution provision will value Series B investment at $0.20/share in order for VCB to own 50% of the company. In that case VCA owns 41.67% and the founders own only 8.33%. The company would be valued at $1,200,000. If the anti-dilution provisions were not in place and $0.20/share was a fair price for the share, the post money valuation of the company would have stood at only $800,000 and VCA and founder would each own only 12.50% of the company with the balance 75% going to VCB. Once again, do note the drastic decrease in percentage equity of the common stock owned by the founder in case of full ratchet anti-dilution provisions. Since full ratcheting preserves the value of investment for Series A investment; there is a maximum threshold to the relative ownership between Series B and Series A owners based on the amount of money they invested. In this case the minimum Series A investor can own is 45.45% whereas the maximum Series B investor can own is 54.54%. As the percentage ownership by Series B investor increases, the value of a share keep decreasing till the overall value of the stock owned by the founders approaches zero.
Without Anti-dilution
Full Ratchet Anti-dilution: Series B investor requires 50% ownership
There are other variants of ratchet based dilution like half ratchet and two-third ratchet based dilution but I shall not go into those details.
The other type of anti-dilution provision is weight based anti-dilution. There are two variants of weight based anti-dilution provisions; broad based and narrow based anti-dilution provisions. The narrow based anti-dilution provisions only consider the outstanding shares on an as converted to common stock basis when calculating the conversion rate. The broad based anti-dilution provisions will account for shares as fully liquidated (meaning it will assume bonds, options, convertible debt etc, have been converted to common stock). I shall not go into the details of broad and narrow based conversion as the difference is self-explanatory The new conversion price for anti-dilution is computed as follows:
NCP = New Conversion Price
OCP = Old Conversion Price
OS = Outstanding Shares prior to new investment
NI = New Invesment (in dollars)
OP = Old Price per share
NP = New Price per share
Once again let us consider our case where VCA makes a Series A investment in XYZ Inc for $600,000 at $1.00/share for 60% of the company, while the founder receives 400,000 common stock shares for 40% of the company. Thus the total outstanding shares are 1,000,000 at a company valuation of $1,000,000.
During a down round, VCB makes a Series B investment of $500,000 at $0.50/share. In this case, we have:
Old Conversion Price (OCP) = $1.00
Old Price per share (OP) = $1.00
Outstanding Shares (OS) = $1,000,000
New Price per share (NP) = $0.50
New Investment (NI) = $500,000
By plugging these numbers into our formula we get the new conversion price of $0.75. Based on this conversion price the Series A investors will be able to convert the investment into a total of 800,000 common stock shares that would be valued at the current market price of $0.50 per share to $400,000. Without Anti-dilution measures, the original Series A investment of $600,000 would be worth $300,000. Do note that unlike full-ratchet based anti-dilution, weight based anti-dilution does not preserve the original value of the investment. The graphs below compare ownership and company valuation based on no anti-dilution measures, full ratchet and weight based anti-dilution. In this case, the value of stock owned by Series A investor varies based on the anti-dilution methods whereas the value of stock both Founder's stock and Series B remains unchanged.
One can tell from the formula for weight based anti-dilution that the new conversion rate is sensitive to the existing outstanding shares, the value of the new investment and the price of a share in the new investment in comparison to the old investment. The conversion price is less affected if there are large number of outstanding shares in comparison to the number of shares issued to the new investor.
For full ratchet anti-dilution, we had covered scenario where the new investor demands a specific level of ownership through their investment. In that case, the new price per share was vaired to match the equity distribution. This process was simpler in full ratchet based anti-dilution as the new price per share and the conversion price were one and the same. A similar demand for ownership in case of weight based anti-dilution would require the conversion price and the new price to vary till the demanded equity distribution is reached. Again, these adjustments will occur at the cost of founder's equity. Since the conversion price is always greater than the new share price in weight based anti-dilution, the founders are likely to retain more equity and value in case of weight based anti-dilution.