Antidilution Protection For Investors
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
In the "modern era" of venture capital (1970 and beyond) the so-called anti-dilution provisions have become increasingly important. Like so many words in the glossary of venture capital, "dilution" has multiple meanings. The core concept, however, arises from a central fact: any new claimant to the assets and/or income of a firm reduces the percentage interests of the existing claimants. Thus, if X and Y own 50 percent of a firm and Z purchases newly issued securities with a claim–say, of 25 percent–on future income or value, X and Y have been diluted in the sense that each necessarily owns a lesser percentage, a lesser claim. It may be, of course, that Z contributes cash or property in an amount sufficient to enable the firm to increase its earnings by, say, 40 percent. In such an event, it is arguable that X and Y's shares have not been diluted in the sense of watered down, because the firm enjoys surplus earning power. Nonetheless, their percentage interest, albeit in a larger pie, is smaller, and some would hold to the theory that X and Y have suffered in some sense.
Several Meanings of "Dilution"
The issue of dilution depends on what criteria are deemed significant in calculating value. If net earnings per share is the measure that drives stock price, then a financing which increases that result is nondilutive; if, similarly, cash flow or gross revenue per share is the critical indicator, the issue is, "Did that indicator go up or down on a per-share basis?" Some firms are given an overall bill of health in terms of return on equity or on assets; a dilutive financing is one that decreases that ratio.
The same analysis can be conducted in terms of book value. If the "shareholders equity" account is $1 million and X and Y each own 50 percent, the appearance of Z, who contributes $100,000 for a 25-percent interest, dilutes X and Y. If Z contributed $400,000 for 25 percent the financing is not normally considered dilutive; dilution in a balance-sheet sense is usually thought to occur only when net book value per share diminishes as a result of the financing. If Z lends the firm $1 million, it is arguable that the claim of X and Y is set back in liquidation, behind an additional layer of debt. However, since the firm has added the loan proceeds to the asset side of the ledger, dilution is not usually perceived as resulting in such instance.
Anti-dilution Formulas
The very nature of a derivative security–a warrant, an option, a convertible preferred–requires some form of anti-dilution protection. Then, if a preferred share is convertible into ten shares of common and something happens to make the common cheaper, the preferred holder desires naturally to be entitled to status quo ante.
And, the easy part of the anti-dilution discussion has to do with recapitalizations (changes in the number of shares outstanding in the absence of an exogenous transaction such as a third-party financing or a consolidation with another firm; that is, stock dividends, stock splits, and reverse stock splits). These changes are technical. A 100-percent stock dividend doubles the number of shares and cuts the book value of the stock in half; absent a market reaction which reflects non-fundamental factors, one $20 share of stock becomes two $10 shares of stock. The more difficult issue arises when a later round of financing is at a lower price than an earlier round or rounds. Thus, assume the company sells preferred stock to investors in an early round, convertible at $1 a share, and then something changes. The issuer needs more money, as start-ups usually do, and so it sells more stock, perhaps common this time, at 75¢ per share. The preferred stockholders are diluted in a sense, but one may argue that such a contingency is a business risk. There were no guarantees when they bought their preferred. The "something" may have had nothing to do with the fortunes of the company; perhaps it is developing in accordance with the plan, but the investment climate changes. If the existing investors want protection against dilution, they can bargain for, and subsequently exercise, preemptive rights, essentially dollar averaging or averaging down to protect their percentage interest. After all, they are the people with cash to spend.
The foregoing is a plausible argument, but it neglects the Golden Rule ("He who has the gold makes the rules"). Anti-dilution provisions tied to the price of subsequent financings operate at the expense of one particular class–the founder and his allies, the key employees— and to the benefit of the other class, the existing cash investors. The new investors, of course, do not care; they get the percentage of equity they bargained for at the specified price. They are either indifferent on the issue, or, because they overlap with the earlier cash investors, are in favor of anti-dilution protection. The founder has only one way to get rich, the horse he is riding, while the professional venture capitalists have a number of irons in the fire. The founder is, therefore, usually outgunned and gives up on anti-dilution provisions. Unfortunately, this can be a big mistake, a point to be revisited after an explanation of the way in which the provisions operate.
Full Ratchet and Weighted Average
There are two principal ways to formulate anti-dilution provisions, capitalizing the terms to make it clear we are talking about the ones that have substantive bite: the "Full Ratchet" and the "Weighted Average." Full-Ratchet provisions are the real killers, at least from the founder's point of view. They provide that, if one share of stock is issued at a lower price, or one right to purchase stock is issued at a lower aggregate price (exercise price plus what is paid, if anything, for the right), then the conversion price of the existing preferred shares is automatically decreased, that is, it "ratchets down," to the lower price. Depending on how many shares (or rights) are included in the subsequent issue, this can be strong medicine. A brief example will illustrate. Assume Newco, Inc. has one million common shares and one million convertible preferred shares outstanding; the founder owns the entire common, and the investors own the entire preferred, convertible into common at $1 per share. Newco then issues 50,000 shares of common at 50¢ per share because it desperately needs $25,000 in cash. To make the example as severe as possible, let us say the investors control the board and they make the decision to price the new round of financing at 50¢. Suddenly the preferred's conversion price is 50¢, the founder goes from 50 percent of the equity to just under 33.3 percent, and all the company has gained in the bargain is $25,000. Indeed, a Full Ratchet would drop the founder from 50 percent of the equity to 33.3 percent if the company issued only one share at 50¢. This is a harsh result, indeed. When a really dilutive financing occurs, say 50,000 shares have to be sold at 10¢ per share, the founder drops essentially out of sight. The company takes in $5,000 and the founder goes down under 9 percent, never to recover because he does not have the cash to protect himself in subsequent rounds. In the jargon of venture capital, he has been "burned out" of the opportunity. There is no other provision so capable of changing the initial bargain between the parties with the dramatic effect of Full-Ratchet dilution. When venture capitalists are referred to as "vulture capitalists," it is likely the wounded founders are talking about dilutive financings and a Full-Ratchet provision.
The more moderate position on this issue has to do with Weighted-Average anti-dilution provisions. There are various ways of expressing the formula, but it comes down to the same central idea: the investors' conversion price is reduced to a lower number but one which takes into account how many shares (or rights) are issued in the dilutive financing. If only a share or two is issued, then the conversion price does not move much; if many shares are issued–that is, there is in fact real dilution–then the price moves accordingly.
The object is to diminish the old conversion price to a number between itself and the price per share in the dilutive financing, taking into account how many new shares are issued. Thus, the starting point is the total number of common shares outstanding prior to the dilutive financing. The procedure to achieve the objective is to multiply the old conversion price per share by some fraction, less than one, to arrive at a new conversion price; the latter being smaller than the former, the investors will get more shares on conversion and dilute the common shareholders (the founder) accordingly. The fraction is actually a combination of two relationships used to "weight" the computation equitably. The first relationship is driven by the number of shares outstanding, the weighting factor, meaning that the calculation should take into account not only the drop in price but the number of shares involved–the significance of the dilution, in other words. (Call the number of shares outstanding before the transaction A.)
The fraction, then, takes into account the drop in price and expresses that drop in terms that can be mathematically manipulated with the first number to get a combined, weighted result. The relationship is between the shares that would have been issued for the total consideration paid if the old (i.e., higher) conversion price had been the price paid versus the shares actually issued (i.e., the shares issued at the new price). (Call these two numbers C and D.)
The combination of these two relationships–number of shares outstanding and the comparative effect of the step down in price (expressed in number of shares)–is a formula:
If the shares that would have been issued at the old (i.e., higher) price are the number in the numerator (as indicated), the fraction or percentage will be less than one. This fraction (e.g. ½ or 0.50) is multiplied by the existing (or initial) conversion price to obtain a lower conversion price, which means in turn that more shares will be issued because the conversion price produces the correct number of shares by being divided into a fixed number, usually the liquidation preference of the preferred stock.
It is open for theorists to argue about the fairness of that result, but the above formula has the advantage of economy of expression. If one wants to use a Weighted-Average anti-dilution formula, the above is one commonly used (albeit sometimes expressed in different terms).