August 24, 2005
Conglomerate Junior Scholars Workshop: Michael Woronoff and Jonathan Rosen on Convertible Securities
Posted by Christine Hurt

Welcome back to the next installment of Conglomerate Junior Scholars Workshop.  Our featured paper today is Understanding Anti-dilution Provisions in Convertible Securities by Michael A. Woronoff and Jonathan A. Rosen, which is forthcoming in the Fordham Law Review.  Woronoff and Rosen have drawn on their own considerable business and practice experience in writing this piece.  Mr. Woronoff is a partner at Proskauer Rose LLP (and former partner at Gordon's and my old haunt, Skadden) and a lecturer at UCLA School of Law, where he teaches a class on venture capital.  Mr. Rosen is himself a J.D./venture capitalist and is associated with Shelter Capital Partners.

Once again, I have turned to Gordon Smith to comment on this paper.  Gordon has recently completed a paper on a different aspect of venture capital contracting that will be forthcoming in the UCLA Law Review.  Here are Gordon's comments:

Almost every time I teach my Law & Entrepreneurship Seminar, one of my students becomes fascinated with the anti-dilution provisions used by venture capitalists, but I have always discouraged them from attempting to focus their research papers on this topic because it seems that a student who is inexperienced in venture capital would have a difficult time saying anything interesting. In this paper, two experienced practitioners of venture capital grapple with anti-dilution provisions, and they have plenty of interesting things to say. If you are new to this topic, however, you may feel that some of the big-picture issues get lost in the detailed description of anti-dilution provisions, so I will focus my brief comments on those big-picture issues and suggest that the paper still needs to travel some distance to reach its proclaimed goal.

The general concept underlying anti-dilution provisions is easy enough to understand. Begin with the concept of dilution: when a company issues new shares of equity, the existing stockholders may be diluted in one or both of the following ways: (1) they may have a smaller ownership interest in the company after the new issuance (Woronoff and Rosen call this "percentage dilution"); and (2) their equity claims may have decreased in value as a result of the new issuance (Woronoff and Rosen call this "economic dilution"). Venture capitalists typically protect themselves against percentage dilution via rights of first refusal -- contract rights that allow the venture capitalists to purchase a specified percentage of any new equity issuances, usually with the goal of maintaining their pre-existing ownership interest. Anti-dilution provisions are aimed at preventing (or muting) economic dilution by requiring the issuance of additional shares (according to a formula specified in the contract) to investors who otherwise would be faced with economic dilution.

As Woronoff and Rosen observe, anti-dilution provisions come in various flavors, and the authors set for themselves the task of explaining the variation. Fortunately for us, they have a theory:

This article provides, for the first time, a comprehensive framework to understand various anti-dilution adjustments and to reconcile the apparent inconsistencies among various clauses. This framework is based on the observation that the scope and extent of different types of anti-dilution provisions can generally be understood as a rational response to the nature and level of the information barriers and agency costs typically confronted in the particular circumstances, and the existence or absence of other mechanisms to address these issues. (31)

So, how well does their theory hold up? In my view, the jury is still out. Consider their argument regarding venture capital, where the "information barriers are severe," thus causing great uncertainty in the pricing of investments. In this environment, the authors claim that anti-dilution provisions act as an ex post adjustment of the prior pricing agreement, using new information gathered from the present pricing negotiations. Evidence of this purpose is found, they assert, in the form of the anti-dilution provisions used in venture capital deals. In every case, those provisions use the initial investment value -- rather than the current market value -- of the preferred stock as the basis for triggering the anti-dilution protections. This is consistent with the notion that the parties are attempting to adjust the results of their prior negotiations, but it is also consistent with the fact that finding a current valuation for private companies is incredibly difficult. And drafting an anti-dilution provision that relied on a current valution that was independent of the negotiated valuation would not only be costly and cumbersome, but potentially quite disruptive to the enterprise if new and old investors begin fighting about the real value of the company.

Moreover, Woronoff and Rosen's theory cannot explain the deep structure of anti-dilution provisions in the venture capital context. Generally speaking, venture capital deals employ one of two types of anti-dilution provision: the ratchet provision or the weighted-average provision. For the details on how each of these provisions works, I refer you to the paper. For present purposes, suffice it to say that the vast majority of deals use the weighted-average provision, even though (according to the authors) the ratchet "is designed to fully protect against inaccurate valuation arising from information barriers." (20) To explain the dominance of the weighted-average provision, the authors must reach beyond their theory of information barriers and price correction. In other words, the observed practice does not seem to be driven by the theory, but by other considerations.

Again, readers are encouraged to comment on this paper by participating in the comments section to this post or by emailing the authors directly. No anonymous comments, please.

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