Every founder and investor fears a down round of financing, which dilutes the value of existing shares. One form of protection against this scenario that is commonly structured into preferred stock is called “anti-dilution protection”.
While generally expressed as a straightforward formula, the financial implications of certain anti-dilution provisions can be significant. If you are considering participating in a round of funding either as a startup or investor, it's important to discuss the implications of your anti-dilution provisions with a financing lawyer.
Understanding Anti-Dilution Provisions
When a startup has a “down round”, shares are sold at a lower price per share than the price paid by investors in the previous financing. Absent anti-dilution protection, such a down round would hurt existing investors by reducing the value of their respective investments in the company. Accordingly, generally VC investors require that anti-dilution protection be a feature of their preferred stock.
Anti-dilution provisions generally give investors the option of convertible securities to recoup original percentage of shares issued during a previous round, so that the new round doesn’t dilute their share without an increase in value. The anti-dilution provision provides a formula for such a conversion.
Generally, preferred stock documents draw on one of two basic anti-dilution formulas used to determine conversion rate -- weighted average and full-ratchet.
Weighted Average Anti-Dilution
The most common anti-dilution formula is weighted average. A weighted average anti-dilution formula calculates the conversion price of the existing preferred stock by looking to the average of the price per share in each of the current and previous financing rounds. The average is weighted based on the amount of money raised in each of the financing rounds considered in the average.
There are two basic variants of this: narrow-based and broad-based.
Narrow-Based Weighted Average. A narrow-based weighted average considers all issued and outstanding common stock calculated into the formula to only include common stock issuable upon conversion. This formula is friendlier to investors who will get a higher conversion rate.
Broad-Based Weighted Average. A broad-based weighted average considers all issued and outstanding common stock calculated into the formula to include not just common stock, but also all stock outstanding and future stocks. This formula is friendlier to the startup.
The full-ratchet anti-dilution formula is the simplest, but also the most burdensome and dangerous for startups. Full-Ratchet anti-dilution reduces the conversion price of already existing preferred stock to the price at which new shares are issued in a later round. This means that if investor bought in at $2.00 per share and a down round later occurs in which stock is issued at $1.00 per share, the investor’s conversion price will convert to $1.00 per share -- regardless of the relative sizes of the financing rounds.
Valuation and Dilution Risk
One way to prevent dilution risk and a down round is to be relatively conservative from an initial valuation standpoint. A solid valuation, even in early rounds, can be helpful as well.
Why is selling shares at a higher price not considered dilution if my ownership percentage will still be reduced?
Although in a sense any further issuance of shares can be considered dilution, the increment on the share price means the valuation of the company went up along with the value of your investment. This indicates a successful investment round—and investors don’t need draw on protective provisions in order to preserve overall value.
What is a “pay to play” clause?
Pay to play provisions tied to anti-dilution provisions qualify them so that only investors that participate in down rounds are entitled to the benefit of the anti-dilution formula in effect. Investors that do not participate do not receive any anti-dilution protection. This protects founders, as it encourages investors to continue to fund the company during lean financial times.