Last 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 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 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.