Key Economic Terms: Anti-Dilution
This post is a continuation of the discussion that covers everything a founder should know before raising their Series A. If you missed the first few posts, you can find them here.
This post continues the discussion around important economic terms in a term sheet with the anti-dilution provision.
Much like the name implies, anti-dilution provisions protect investors from getting diluted. However, the anti-dilution protection is price based, meaning the provision will only apply when preferred stock is issued at a lower price than what the investor paid for their shares; i.e. a down round. Like most terms, anti-dilution provisions range from either startup friendly (broad based weighted average) to investor friendly (full ratchet).
Broad based weighted average anti-dilution takes the number of shares issued during the down round into account when repricing the Series A round. It’s time to head back to algebra class as the following formula is used:
NCP = OCP * ((CSO + CSP) / (CSO + CSAP))
- NCP = new conversion price
- OCP = old conversion price
- CSO = common stock outstanding
- CSP = common stock purchasable with consideration received by company (i.e. “what the buyer should have bought if it hadn’t been a ‘down round’ issuance”)
- CSAP = common stock actually purchased in subsequent issuance (i.e., “what the buyer actually bought”)
We won’t dive deep into the weeds on this one with an example (as I am sure it would put many readers to sleep), but it is important to note that the price being recalculated is the conversion price. Remember that normally preferred stock in venture financings is convertible into common at the option of the investor. Therefore, no new stock is reissued at this point in time. The provision will apply later on down the road at a liquidation event such as an acquisition.
Full ratchet anti-dilution is much harsher on the startup. For example, let’s say your Series A round is $1 per share and your Series B is at $.50 per share. Let’s also say the Series A investors have full ratchet anti-dilution protection. What happens is that the Series A round is effectively repriced to $.50 per share. This results in more shares to the Series A investor and more dilution to the founders. Ouch.
It is clear that when you are negotiating with investors, you want some form of weighted average anti-dilution provision (like broad based) instead of full ratchet. Also it is important to try to negotiate some carve outs for when the anti-dilution provision won’t apply. One carve out you should try to get is to have the anti-dilution provision waivable by a majority, in terms of shares, of the Series A investors. This can be beneficial to your startup and those investors who want to continue to fund your startup in follow on rounds. In short, it will prevent investors from “cashing in” on the down round (by not investing and getting more equity in your startup via the anti-dilution provision) by forcing them to either buy in at the new round or be diluted. Finally, it is always important to discuss these anti-dilution provisions with an attorney who routinely handles these matters.
That concludes our “Key Economic Terms” portion of this series. Next we will begin discussing the key control terms in a term sheet.