Anti-dilution rights, in particular the anti-dilution formula, are very difficult to understand but give the investors critical “down round” protection (i.e., the company selling shares of stock in the future at a purchase price below the price paid by the investors).
Price-based anti-dilution provisions are perhaps the most esoteric and difficult provisions in a venture capital or sophisticated angel preferred stock financing (certainly from a drafting perspective in the corporation’s Certificate of Incorporation).
Anti-Dilution Rights are Conversion Rights for Preferred Stock that is Convertible into Common Stock
In a nutshell: the Preferred Stock is convertible into common stock. The underlying common stock of the Preferred Stock is where all of the “up side” for the investors is (see related blog posts Term Sheet 101: The Liquidation Preference and Less Risk, More Reward, discussing how investors maximize their returns by purchasing preferred stock that is convertible into common stock). The Preferred Stock will always start out convertible one-for-one (1:1) into shares of common stock. What price-based anti-dilution protection affords the investors is a mechanism for adjusting the conversion rate of the Preferred Stock if the corporation sells shares of capital stock at a price below the price per share paid by the preferred investors, what is called a “down round.” If that happens, the anti-dilution rights provide that the conversion rate of the Preferred Stock will adjust, providing the investors with more underlying conversion shares.
The big question is, how much will the conversion rate adjust? Both “broad based” and “narrow based” anti-dilution methods use a weighted average, mathematical formula approach for determining the new conversion rate of the Preferred Stock. The conversion rate = purchase price per share / conversion price. The conversion price starts as the purchase price per share. Anti-dilution provisions lower the conversion price, and so by lowering the denominator in this formula, the conversion rate of the Preferred Stock into common stock is increased.
Weighted Average Anti-Dilution Rights
The weighted average approach takes into account both the new price per share at which shares of capital stock are sold (the lower, the more dilutive) and the number of dilutive shares sold (the higher, the more dilutive). The formula is as follows:
This is complicated! – but here is the key to understanding the anti-dilution formula: how the term CS, or number of shares of common stock outstanding, is defined.
Broad-Based Weighted Average Anti-Dilution Rights
In a “broad based” weighted average anti-dilution formula, CS is defined as broadly as possible to include common stock outstanding, the common stock issuable upon conversion of outstanding Preferred Stock and the common stock issuable upon exercise of all outstanding options and warrants. Broad based anti-dilution adjustments are the most favorable to the holders of common stock because it makes the least adjustment. CS is in both the numerator and the denominator, so the larger that number the less impact the dilutive issuance will have on the New CP.
Narrow-Based Weighted Average Anti-Dilution Rights
“Narrow based” anti-dilution adjustments (used far less often than broad based adjustments in deals) uses the same formula but defines CS more narrowly. CS may include just the common stock outstanding (and not the common underlying Preferred Stock and outstanding options and warrants)—this is very “narrow”, or CS may include the common stock outstanding and the common stock underlying the Preferred Stock (but not the common stock underlying options and warrants)—still narrow, but not as narrow.
Full Ratchet Anti-Dilution Rights
The “Full Ratchet” anti-dilution rights can be outright draconian. the full ratchet does not use a formula but simply adjusts the old conversion price to equal the new purchase price per share in the dilutive issuance—essentially re-pricing the entirety of the Preferred Stock financing to the price of the new shares sold after the financing. The full ratchet anti-dilution adjustment can be fair in certain circumstances, but what can be draconian is a complete repricing of the Preferred Stock financing if there is a very small (in theory, as little as 1 share) dilutive issuance that economically has minimal impact.