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Whenever a company issues new shares during a fundraise, existing shareholders have their ownership stake diluted. A common scenario that can cause friction in a venture deal is when a company experiences a “down round,” meaning the company raised money at a lower valuation than the previous fundraising round.
When this happens, the level of dilution experienced by earlier investors is greater than it would be if the company had raised a new round at a higher valuation. This is because the new investors paid less per share than the earlier investors. To relieve this friction, founders and investors rely on anti-dilution provisions.
Anti-dilution protection provisions are important for any venture investor to understand because of the significant impact they can have on the economics of a deal—and future deals—as well as the relationship between investors and founders.
Let’s take a look at an example to understand the mechanics of a down round and the issues they raise for investors.
We’re going to compare the post-money valuation of one round (how much the company is worth after taking new funds) to the pre-money valuation of the following round (how much the company is worth before taking new funds) to determine if it’s an up or a down round.
Suppose a company is valued at $9M before raising any money—the company’s “pre-money” valuation. The company raises a $3M Series A round and is now worth $12M—its “post-money” valuation (which is the most common way valuations are reported and the number used to determine an investor’s ownership stake in the company).
A year later the company needs more money, but the underlying economics have changed. Investors drop the value of the company to $10M (the new “pre-money” valuation). No matter how much gets invested during this round, it’s a down round because the pre-money valuation dropped compared to the most recent post-money valuation of $12M.
Now, let’s take a look at how this impacts investors.
Let’s say you were the sole investor in the Series A round. You invested $3M and own 25% of the company (based on the post-money valuation of $12M). Your shares are worth $3M.
During the Series B (which you decide to skip, for the purposes of this example), the company raises $10M based on the reduced pre-money valuation of $10M, bringing the new post-money valuation to $20M.
Because the pre-money valuation decreased, the value of your shares decreased from $3M (following the Series A) to just $2.5M (following the Series B). This happened because other investors bought 50% of the company at a lower price-per-share (PPS) than what you paid.
PPS is key to understanding dilution. The PPS formula is as follows:
PPS = pre-money valuation / total fully-diluted capitalization of the company on a pre-money basis
Fully-diluted capitalization assumes all preferred stock has been converted to common stock, outstanding options, warrants, and securities have been exercised, and shares reserved for issuance under a stock plan have been exercised.
Given this context, if the fully-diluted capitalization of the company prior to the Series A investment is 9M shares, and you bought a 25% stake for $3M (which implies a $9M pre-money valuation), it means the PPS was $1 ($9M pre-money valuation / 9M shares = $1)."
For the Series B, the fully diluted capitalization of the company was 12M shares, and the investors bought 50% of the company for $10M. This made the PPS $0.83 ($10M / 12M shares = $0.83).
In short, your ownership stake and equity value both decreased.
Your shares after Series A
3/12 (25%) of $12M = $3M
Your shares after Series B
(Other investors) 10/20 (50%) of $20M = $10M
(You) 25% of the remaining $10M = $2.5M
Anti-dilution protection is how investors protect themselves in a down round.
Anti-dilution is triggered when the conversion price for a round is less than the conversion price from the prior round (which is almost universally the same as the PPS for the preferred stock sold in that round). An anti-dilution provision typically increases the number of common shares each preferred share converts to in a new capital raise.
This is important because investors have two options to cash out in a liquidity event—convert their preferred stock to common stock and share ratably (proportionally) in the proceeds, or keep their preferred stock and collect their liquidation preference before the common receives any proceeds. Investors will always choose the higher amount, and anti-dilution protection enables investors to maintain their ownership stake to capture more of the exit proceeds than they otherwise would if they converted to common stock.
There are two types of anti-dilution protection: full-ratchet anti-dilution protection and weighted average anti-dilution protection.
Full-ratchet anti-dilution is the easiest to calculate and also the least common method. It uses the lowest preferred share price as the conversion price for holders of preferred shares.
Weighted average anti-dilution protection is far more common. As the name implies, this method applies a price based on the weighted average price all investors have paid so far.
Full-ratchet anti-dilution protection is the strongest form of anti-dilution protection, which is one reason it’s used less (more on this later). Here, the new conversion price adjusts to the lowest conversion price implied by any financing round. The formula is:
Number of common shares = (Number of preferred shares) x (Original share price/Conversion Price)
Let’s look at an example based on the aforementioned sample company.
Without any anti-dilution protection, you would convert your 3M preferred shares into common shares at your original price of $1.00 per share. This would give you 3M common shares—each now worth only $0.83—and a 12.5% ownership stake in the company (down from $1 per share and 25% of the company).
With full-ratchet anti-dilution protection, you could convert your 3M preferred shares into common shares at the new lower price of $0.83 per share that Series B investors paid. This conversion would give you about 3.6M shares, each valued at $0.83, effectively preserving the original value of your stake (but still diluting your ownership stake).
For weighted average anti-dilution protection, the conversion price is not automatically lowered to the lowest share price. Instead, it’s modified based on the increase in the number of shares the company issued. Here's the formula:
Let’s apply this formula to our sample company:
New conversion price = $1.00 x (12M + $10M/$1.00) / (12M + 12M) = $0.92
Under this formula, your 3M Series A preferred shares would convert to about 3.27M common shares (3M/$0.92 per share) in the event of an exit. The value of your investment dropped by about 9% ($3M to $2.71M). You didn’t fare as well as you would have with full-ratchet anti-dilution protection, but this approach did prevent some dilution.
There are two ways to calculate weighted average anti-dilution: broad-based and narrow-based. The formulas are identical, aside from the number used for outstanding shares.
For broad-based weighted-average anti-dilution, the number of outstanding shares includes all types of issued shares, including outstanding options and warrants. Narrow-based only takes into account the total number of outstanding preferred shares, and excludes options, warrants, and shares issued as part of employee options pools.
Because of how the formula works, broad-based anti-dilution results in a higher conversion price than narrow-based—meaning preferred shareholders get fewer shares when they convert them.
Narrow-based is better for investors, while broad-based is better for founders.
The more shares held by preferred shareholders, the less ownership for common stockholders such as founders and employees. In other words, the stronger the anti-dilution protection for investors, the greater the potential dilution for founders.
For this reason, founders often push back against anti-dilution protection clauses and advocate for a broad-based weighted average. What provision ultimately makes it on the term sheet depends on each party’s negotiating leverage.
Here are a few important things to keep in mind when negotiating these provisions: