March 22, 2005
VC Term Sheets: Anti-Dilution
Posted by Gordon Smith

No provisions in venture capital contracts are more complicated than the anti-dilution provisions. Brad Feld tackles this topic in his series on venture capital term sheets. The basic concept motivating these provisions is that existing investors do not want to have their interests in the portfolio company diluted by subsequent issuances of equity. A quick example might help.

Let's say that I have purchased 1 million shares of convertible preferred stock (a 25% interest) in Company A for $10,000,000 or $10 per share. If Company A now proposes to sell another 1 million shares, but this time for half that price ($5), I would be concerned. My ownership interest in the company would decrease to 20% (I would own 1 million of 5 million total shares, rather than 1 million of 4 million total shares), and my shares would have a an implied valuation of $5,000,000 (that's my 1 million shares multiplied by the new issue price of $5). Ouch!

One way to protect my investment would be to adjust the conversion ratio of my shares. At the outset, we peg that ratio at one preferred share for one common share. We do this with a simple formula, which defines the conversion ratio as the original purchase price of the shares divided by the "conversion price." We initially define the "conversion price" to be the same as the original purchase price, but allow for downward adjustment of the conversion price in the event of a "dilutive issuance" -- an issuance of more equity for a lower price than I paid.

There are two ways to make that adjustment. We could just lower the conversion price to the new lower equity price. In my example, that would be $5. To calculate the conversion ratio, therefore, simply divide the original purchase price of my shares ($10) by the new conversion price ($5). In other words, every share of my preferred stock would now be worth two shares of common stock, not just one. As a result, my ownership interest in the company would equal 33% (2 million of a total of 6 million shares, assuming no other shareholders with anti-dilution protection), which would have a value of $10 million (my 2 million shares multiplied by $5 per share). This is called the "rachet method," and it is relatively uncommon in venture capital deals because it is viewed as too favorable to the venture capitalist.

The more common method is the so-called weighted average method, which computes a new conversion price via the formula described in Brad's post. In our example, the new conversion price after the issuance of an additional 1 million shares at $5 would be $9 (do the math!). Under this rule, I would received 1.11 shares of common stock upon the conversion of each share of my preferred stock. My stake in the company would equal 21.7% (1.11 million of a total of 5.11 million shares, assuming no other shareholders with anti-dilution protection), which would have a value of $5.55 million (my 1.11 million shares multiplied by $5 per share). As you can see, this is not as favorable to me as the rachet method, but it is more favorable than no anti-dilution protection.

Brad observes that these provisions appear in almost every transaction and have important control consequences for the venture capital relationship.

In addition to economic impacts, anti-dilution provisions can have control impacts. First, the existence of an anti-dilution provision incents the company to issue new rounds of stock at higher valuations because of the ramifications of anti-dilution protection to the common stock holders. In some cases, a company may pass on taking an additional investment at a lower valuation (although practically speaking, this only happens when a company has other alternatives to the financing). Second, a recent phenomenon is to tie anti-dilution calculations to milestones the investors have set for the company resulting in a conversion price adjustment in the case that the company does not meet certain revenue, product development or other business milestones. In this situation, the anti-dilution adjustments occur automatically if the company does not meet in its objectives, unless this is waived by the investor after the fact. This creates a powerful incentive for the company to accomplish its investor-determined goals. We tend to avoid this approach, as blindly hitting pre-determined (at the time of financing) product and sales milestones is not always best for the long-term development of a company, especially if these goals end up creating a diverging set of goals between management and the investors as the business evolves.

Great insights here. And I agree with Brad that the powerful incentives that seem so attractive when the contract is drafted might not seem so wonderful when the whole drama has unfolded.

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