Monthly Archives: May 2011

Venture Capital Terms: Common Types of Anti-Dilution Provisions

Calculating Anti-Dilution ProtectionLast week, I posted a general discussion of anti-dilution protection, and how it’s included by VCs in term sheets to help mitigate the dilutive effects of a down round. As we saw last week, while such provisions help protect a VC’s investment when a company’s valuation drops, they provide no protection for common stockholders such as founders and company management. In fact, when VCs exercise such provisions, it actually magnifies the dilution experienced by the common.

This week, I wanted to expand this discussion by describing some common types of anti-dilution protection and what they mean. In last week’s post, I said that the mechanism by which anti-dilution provisions protect VCs is by altering the price at which their original investment converts to shares, thus allowing them to purchase shares at a price lower than the originally negotiated share valuation. The new conversion price depends on the type of anti-dilution provision that was in the original term sheet.


Full Ratchet

Full Ratchet is the form of anti-dilution protection that most strongly favors VCs. In this type of provision, the conversion price is set to be equal to the share valuation at the current down round. For example, if a venture firm called XYZ Ventures initially invests $2M at a share price of $2 per share in a Series A, the firm expects to own 1M shares in the company at the original purchase price. Now imagine the company fails to perform as expected, and when it raises the Series B, it receives a share valuation of only $1 per share. If the Series A term sheet included full ratchet anti-dilution, then the conversion price for the Series A investment is reset to the new valuation of $1. This means that XYZ venture’s initial $2M investment will actually buy them 2M shares instead of the original 1M.

Since full ratchet protection allows previous rounds to be re-priced at the same price as any future down rounds, it effectively prevents any dilution to the protected VCs. It is essentially a “low price guarantee” for VC firms, since it allows their original investment to purchase shares at the lowest price offered at any point in the future. Conversely, it is the least favorable provision to common shareholders, since it leads to the greatest number shares outstanding, and therefore the greatest degree of dilution of the common.


Weighted Average

Weighted average anti-dilution is less extreme than full ratchet, in that it reduces the conversion price of previous rounds, but does not set the conversion price equal to the price of the current down round. Thus it reduces the dilution experienced by protected investors in previous rounds, but does not eliminate the dilutive effect of a down round. The idea behind the weighted average is that the reduction in conversion price is computed as a function of the percent of the total shares outstanding that are owned by each investor. In this way, investors that own a larger percentage of the company receive greater protection from weighted average of provisions.

There are two sub-types of weighted average protection. Broad based weighted average calculates the total shares outstanding by including all preferred stock, common stock, as well as unexercised securities such as employee stock options. Narrow based weighted average includes only those shares which are currently outstanding, and excludes unexercised options. Thus, the narrow-based calculation is a little more favorable to VCs since it assumes a larger percent ownership, and thus a larger adjustment of the conversion price, for each investor.



  • Anti-dilution protection protects VCs by re-pricing their original purchase of shares at a down round.
  • Full ratchet protection effectively eliminates dilution of protected VCs at a down round by setting their conversion price to the share price of the down round.
  • Weighted average protection is less favorable to VCs than full ratchet, since it reduces the conversion price, but does not set it equal to the current valuation.
  • Anti-dilution provisions are most favorable to VCs lead to the greatest dilution of common stockholders if a down round occurs.

Venture Capital Terms: Anti Dilution Protection

Anti-dilution: planning for a rainy dayNegotiating a venture capital financing is often difficult for those not familiar with the meaning of some common VC deal terms. Share price and liquidation preference are among the most sensitive terms when determining the value of equity held by VCs and company founders. In comparison, the inclusion of anti-dilution protection in a deal has the potential to exert nearly as large an effect on returns, but is generally much less well understood, particularly by first-time entrepreneurs seeking funding.

I therefore thought I’d use this post as an opportunity to introduce the basics of anti-dilution provisions and what they mean to VCs and common stockholders. I will discuss some common types of anti-dilution protections in a follow-up post next week.


What is dilution?

Broadly speaking, dilution occurs anytime new shares are issued in a company. For example, if a particular stockholder owns 100 shares in a company that has 1,000 total shares outstanding, he owns 10% of the company. If an additional 1,000 shares are later issued, the stockholder is diluted since he now owns 100 out of 2000 shares, or 5% of the company.

By the above definition, dilution occurs every time a new financing occurs. When VCs make an investment, they purchase shares which are issued at the time of the financing. This dilutes the percent ownership of all existing stockholders, since new shares are issued. However, if all goes well and each round of financing is accompanied by an increased share valuation, the reduction in the actual percent ownership for each stockholder is more than offset by the increased value of each share.

If, on the other hand, the company experiences a “down round”, i.e. a round of financing that comes with a reduced valuation compared with the previous finance round, the dilution causes a reduction in the actual monetary value of each shareholder’s equity. To protect themselves from this eventuality, VCs often include anti-dilution protections in term sheets.


Who is protected and how?

The first thing to realize about anti-dilution protections is that they protect the preferred stockholders from previous rounds in the event of a down round, but do not protect company founders and other common stockholders. In fact, when a VC exercises his anti-dilution rights, it actually causes additional dilution to common stockholders.

The basic mechanism by which VCs are protected by anti-dilution provisions is that the conversion price (the price at which their original investment is converted to shares) is reduced. The actual amount by which the conversion price is reduced is determined by the type of anti-dilution protection in the term sheet, but the basic effect is that the VC gets to purchase shares at a lower price than the original purchase price. So although this helps offset the dilutive effect on the protected VCs, it leads to additional shares outstanding, and therefore magnifies the dilutive effect of the down round for all non-protected shareholders such as company founders and management.

Anti-dilution protections become an even more important factor in a down-economy. Anyone negotiating a term sheet in the current economic climate must carefully consider the anti-dilution protections included. Down rounds have become increasingly common as companies struggle in a more difficult market, so anti-dilution protections are more relevant than ever.



  • All shareholders are diluted whenever new shares are issued, but as long as share valuation increases with each finance round, the dollar value of everyone’s equity stake still increases.
  • In the event of a down round, VCs can exercise their anti-dilution protections which help offset the dilutive effect for the VC.
  • Anti-dilution protections only protect preferred stockholders, and actually lead to additional dilution of common stockholders at a down round.

Venture Capital Fundraising Made Easy

For a first time entrepreneur or even a veteran of several startups, raising venture capital is one of the hardest tasks to do properly.  It is enormously time consuming and can be a major distraction from the execution of your business objectives.  It is often a necessary step in a company’s life cycle to accelerate development, improve sales, and realize a successful exit. Venture Capital Fundraising Made Easy Much has been written on this subject but there are few guides that work through the process, step-by-step from the perspective of a recovered investment banker.  So what are some things that can be done to improve this process and get the best deal possible?

This venture fundraising blog series will discuss the financing process, which if done properly, will ensure a well-run process and hopefully competitive term sheets for your company.

The process can easily be broken down into the following 10 steps:

  1. Kickoff Meeting and Division of Responsibilities
  2. Business Plan/Private Placement Memorandum and Management Presentation Preparation
  3. Due Diligence Preparation
  4. Initial Outreach
  5. Management Presentation
  6. Investor Follow-up and Due Diligence
  7. Receipt of Term Sheets
  8. Negotiation of Term Sheets and Build Syndicate
  9. Draft and Negotiate Legal Documents
  10. Deal Close

These steps are not discrete and are often represented differently or in a different order depending on someone’s perspective.  That said, all of these must be followed via a structured process to be successful.  We will go into greater depth on each of these in subsequent posts.  Please leave a comment or email me if you have any thoughts or things that we should include.  Have you had a different experience than this?

Venture Capital Terms: The Importance of Liquidation Preference

Liquidation Preference: Who gets paid what?As many entrepreneurs discover when they first begin to seek venture capital funding, VC term sheets can be very complex. Naturally, each term in a proposed deal is subject to negotiation, but it is not always clear which terms have the greatest impact on the company’s shareholders.  I therefore thought I’d highlight one extremely important but often misunderstood deal term: liquidation preference.

Although liquidation preference is nearly as important as share price in determining the value of equity held by a company’s founders, management, and VCs, it is often overlooked by entrepreneurs during negotiation because it is unfamiliar to those who have limited experience with venture capital.


What is liquidation preference?

So what is liquidation preference, anyway? Liquidation preference determines the order in which the various shareholders of a company get paid upon the liquidation of the company. When venture firms invest in a company, they generally purchase preferred stock, which means they get to redeem their shares before common stockholders like founders and company management.

The exact amount VCs get to collect as part of this preferred payout is determined by the preference multiple, which is a multiple of the original purchase price. For example, if a VC firm purchases preferred stock with a 2X liquidation preference, then they have the right to get paid double their original investment before the common stockholders get paid anything. It is not difficult to imagine that this preference might be extremely important under the right circumstances. For instance, if a VC has invested $10M with a 2X liquidation preference, and the company sells for anything less than $20M, then the common stock held by founders and management becomes worthless – the VC collects the entire exit proceeds.



Another important aspect of liquidation preference is participation. Many term sheets grant VCs the right to participate with common shareholders pro rata (i.e. proportional to the percent of the company they own) even after they have been paid their preference multiple.

To illustrate what this means, let’s continue the example above. Suppose a VC has invested $10M in a company, with a 2X liquidation preference. Let’s imagine that the VC owns 80% of the company’s shares, the remaining 20% are retained by common stockholders at the company, and the company sells for $25M.

Without participation, the VC gets paid $20M (its 2X liquidation preference), and the remaining $5M is paid out to the common stockholders. In that case, the common receives 20% of the exit proceeds, as might be expected from their percent ownership. If the VC’s preferred stock has participation rights, however, then the leftover $5M is split 80/20 ($4M / $1M) between the VC and the common. So even though the common stockholders own 20% of the company’s shares, they will actually receive only $1M of the $25M sale!

To limit the benefit received by VCs from participation, some term sheets contain a “cap”, a multiple of the original investment at which VCs no longer get to participate until they let the common “catch up” to their ownership percentage. Such caps benefit the common by allowing them to be paid their full ownership percentage, but this requires the company to sell for an amount higher than the cap in order to be effective.



  • Liquidation preference has a potentially huge impact on the payout to common stockholders, and should not be overlooked during negotiation.
  • Term sheets with higher preference multiples and participation rights favor VCs.
  • Those with lower multiples and no participation (or capped participation) are more favorable to the company.