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ANTI DILUTIONINVESTOR PROTECTION RIGHTS

Concept – Pre Money / Post Money Valuation

Concept / Types of Anti Dilution

Anti Dilution Adjustment Mechanisms

Negotiating Anti Dilution provisions in VC/PE Term sheets

Contents

Pre Money Valuation = Valuation of the company prior to Investment Post Money Valuation = What is the valuation of the company Post investment Post Money Valuation = Pre Money Valuation + Investment Amount Ownership % = Investment / Post Money Price Per share = Pre Money Valuation / Pre Money shares

Example 1 :  VC investor offers to invest $3MM into a startup for 30% of the company.  Post Money valuation = $3m / 0.30 = $10Mn

Example 2 : VC investor invests $4Mn investment at a $6Mn pre-money Post Money = Pre Money + Investment Post Money = $6Mn + $ 4Mn = $10Mn

Concept – Pre Money / Post Money

Dilution refers to the phenomenon of a shareholder’s ownership percentage in a company decreasing because of an increase in the number of outstanding shares

 Value of the portion of the company owned by investor increases when company valuation increases

Anti-dilution protection refers to protection from dilution when shares of stock of stock are sold at a price per share less than the price paid by earlier investors

These Provisions get triggered in the context of a “downround”

Concept – Anti Dilution Protection

Price Based Anti-dilution Price-based anti-dilution adjustments involve increasing the number of shares of

common stock into which each share of preferred stock is convertible Structural Anti dilution

This is an adjustment of the conversion price of their preferred stock into common stock upon the occurrence of any subdivisions or combinations of common stock, stock dividends and other distributions, reorganizations, reclassifications or similar events affecting the common stock.

This type of anti-dilution protection ensures that the investor holding preferred stock is treated as if such investor held common stock without the need to actually convert into common stock and lose the features associated with the preferred stock held by such investor

Types – Anti Dilution Mechanisms

Full ratchet works by simply reducing the conversion price of the existing preferred to the price at which new shares are issued in a later round

Puts shareholders in the same position as if they had made their invest at the new lower price.  

With this approach, the common stockholders bear all of the downside risk while both common and preferred share in the upside

Full ratchet can also make later rounds more difficult Dilutive effect on the ownership percentages of the founders and management can be

severe and destabilizing for the company.

Full Rachet Anti Dilution

Series A Preferred investors valued a company ABC Ltd at $50 million on a post-money. Series A Investors Purchased four million shares at $5.00 per share, for a 40% interest in the company . Remaining stake held by Promoters. Assume that New investor B has valued the company for $25M pre money. Series B investor Invests $6.25Mn for 20% stake post Money

Since Series B investment is coming in at lower price per share compared to Series A due to drop in Valuation, anti dilution provision gets triggered for Series A Investors

In Full Ratchet Series B price per share gets applied to Series A resulting in anti dilution shares being issued to Series A investors to enhance their ownership stake.

Please refer the excel sheet for detailed working

Full Rachet Anti Dilution – Example

Broad Based Anti dilution Broad Based Weighted Average Anti Dilution

Weighted average – The conversion price adjustment that early shareholders are entitled to is a function of shares outstanding and shares issued in the down round

Formula results in reduced weighted average conversion price for Series A investors resulting in higher conversion rate

 Assumes conversion of all preferred stock, warrants, stock options and other convertible securities

 Most common kind of anti-dilution formula, and is usually not objected to by later shareholders

Broad Based Anti dilution – Formula Broad Based Weighted Average Anti Dilution Formula:

  NCP   =    CP     x    (CSO   +   AC/CP)/(CSO   +  AS),    

  where  NCP = New weighted average conversion Price of Series A investor        CSO  = Common stock outstanding before the new round (including dilutive securities)       AC  =   New Investment – Series B        CP   =   Old conversion price        AS   =  Number of shares to be issued in new round

Broad Based Anti dilution – Example Series C Pre financing capitalization Table of company ABC

Also assume that there is a dilutive financing with the issuance of 2,000,000 shares of Series C Preferred Stock at $0.50 per share, for total gross proceeds of $1,000,000.

 

Shares Type of securities 15,00,000 Common Stock 25,00,000 Series A Preferred Stock (issued at $1/share) 20,00,000 Series B Preferred Stock (issued at $2/share) 10,00,000 Options 70,00,000 Total

Broad Based Anti dilution – Example Series A conversion Price adjustment :

= $1* ((70,00,000+(10,00,000/1) / (70,00,000+20,00,000))

= $1 *(8/9) = $0.88 = New weighted average conversion price

Thus, the number of shares of common issuable upon conversion of Series A is:(2,500,000) x ($1.00 / $0.88) = 2,812,500

This results in a Series A Conversion Rate of 1.125:1

Series B conversion Price adjustment :

= $2 * (((70,00,000+(5,00,000/1) / (70,00,000+20,00,000)) = $2 * (7.5/9) = $1.67

Thus, the number of shares of common issuable upon conversion of Series B is:(2,000,000) x ($2.00 / $1.67) = 2,400,000 This results in a Series B Conversion Rate of 1.20:1

Also assume that there is a dilutive financing with the issuance of 2,000,000 shares of Series C Preferred Stock at $0.50 per share, for total gross proceeds of $1,000,000.

 

Narrow Based Anti dilution Narrow Based Weighted Average Anti Dilution

Only difference in Broad based and Narrow based is what constitutes CSO used in the formula for arriving reduced conversion Price

The Formula does not take into account any dilutive securities  Formula results In reduced weighted average conversion price & higher

conversion ratio for Series A & B investors compared to Broad based Anti dilution (Prior example)

Comforting To Promoters compared to Full ratchet. However, higher magnitude of conversion price adjustment compared to Broad based anti dilution

Narrow Based Anti dilution – Formula Narrow Based Weighted Average Anti Dilution Formula:

  NCP   =    OCP     x    (CSO   +   AC/CP)/(CSO   +  AS),    

  where  NCP = New weighted average Conversion Price of Series A investor OCP = Old conversion Price at Series A        CSO  = Common stock outstanding before the new round (excluding dilutive securities)       AC  =   New Investment – Series B        CP   =   Old conversion price        AS   =  Number of shares to be issued in new round

Thank YouAbout the Author:He is an MBA (Finance) with over 8 years of experience into investment banking. Have undertaken extensive training in financial modelling and has strong deal origination and execution experience on Private Equity, M&A & Debt Syndication transactions across various sectors.

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