Anatomy of a Term Sheet 8 — Anti-Dilution Protection

Welcome back to our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth. The goal is to give startup founders a solid understanding of the complex provisions of the term sheet. We have had 7 installments so far, covering topics like the option pool, voting rights, the liquidation preference, dividends, conversion, and protective provisions. 

The next item in our Anatomy of a Term Sheet series is the anti-dilution term. This post will have some math in it, including a formula, but there won’t be a test or pop quiz. And no quadratic equations or string theory. Promise.

The anti-dilution term is designed to protect the Series A investor from dilution in case the startup issues new shares in a later round at a price lower than the price paid by the Series A investors. Along with the liquidation preference, anti-dilution protection is a signature feature of preferred stock. Typically, the Series A preferred shares will convert into common stock on a 1-to-1 basis. Anti-dilution provisions are designed to increase the number of shares of common stock into which each preferred share is convertible. Since the Series A preferred stock votes on an as-converted basis, anti-dilution provisions also affect voting rights.

Here are how the three alternative anti-dilution provisions look in the model term sheet:

In the event that the Company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be adjusted in accordance with the following formula:

Alternative 1:  “Typical” weighted average:

CP2 = CP1 * (A+B) / (A+C)

CP2 = Series A Conversion Price in effect immediately after new issue

CP1 = Series A Conversion Price in effect immediately prior to new issue

A = Number of shares of Common Stock deemed to be outstanding immediately prior to new issue (includes all shares of outstanding common stock, all shares of outstanding preferred stock on an as-converted basis, and all outstanding options on an as-exercised basis; and does not include any convertible securities converting into this round of financing)

B = Aggregate consideration received by the Corporation with respect to the new issue divided by CP1

C = Number of shares of stock issued in the subject transaction

Weighted average anti-dilution protection is the most common form, and luckily, that’s the only formula you’ll see today. Like I promised, no quadratic equations, and no string theory. Let’s plug some numbers into the formula to see how it works:

Our startup company, Greasy Lake, Inc., has 4 million common shares outstanding, plus 1 million common shares in the option pool, and 2 million Series A preferred shares, which are convertible into common stock. Thus, the total number of shares outstanding (“A” in our formula) is 7 million shares. The Series A conversion price prior to the new financing is $1 (this is “CP1” in our formula). The Series A investor is Jimmy the Saint Fund.

Greasy Lake is going through a Series B financing, in which Hazy Davey Fund is going to invest $2 million, at a price per share of $0.50. Consequently, it will be purchasing 4 million Series B preferred shares. Because the price per share in the Series B round is less than the price per share in the Series A round, anti-dilution protection is triggered.

B” in our formula, therefore, is $2 million divided by $1, or $2 million. “C” in our formula is 4 million, the number of shares being issued in the Series B round. Now we can plug those numbers into the formula.

CP2 = CP1 x (A + B)/(A + C)
= 1 x (7,000,000 + 2,000,000) / (7,000,000 + 4,000,000)
= 1 x (9,000,000)/(11,000,000)
        = 1 x 0.818
= 0.818

So our new Series A conversion price is now $0.818. Without the anti-dilution protection, Jimmy the Saint Fund would convert its 2 million Series A preferred shares into 2 million shares of common, at a 1:1 ratio. Applying the anti-dilution protection, however, enables Jimmy the Saint Fund to obtain a larger number of common shares upon conversion – 2 million divided by 0.818, or 2,444,988. The new conversion rate is 1.2:1, instead of 1:1.

OK, that’s pretty much it for the math. Keep in mind, the actual formula in a specific term sheet may vary somewhat from what we have here. The important takeaway, however, is that anti-dilution protection is designed to adjust the conversion price, so that earlier venture capital investors can convert their preferred shares into a greater number of common shares.

Alternative 2:  Full-ratchet – the conversion price will be reduced to the price at which the new shares are issued.

As a reward for suffering through all that math, we have our second alternative for anti-dilution protection, which is called “full-ratchet.” This is much simpler than the weighted average approach. You simply reduce the conversion price of the existing preferred stock to the same price per share being paid in the new, dilutive round of financing.

So, if Jimmy the Saint Fund’s Series A preferred stock was sold at a price per share of $1.00, and Hazy Davey Fund is paying $0.50 per share for the Series B preferred, then Jimmy the Saint’s conversion price is reduced to $0.50/share. The effect is that Jimmy the Saint Fund had been able to convert each share of Series A preferred stock into one share of common stock, and now it can convert each share of Series A preferred stock into two shares of common stock.

The problem with full-ratchet is that it is something of a blunt instrument: the conversion price reduction is the same whether Greasy Lake raises $5,000 at $0.50/share, or $5 million at $0.50/share. With the weighted average approach, on the other hand, the amount of money raised influences the new conversion price. The full-ratchet approach benefits the investor, because it offers full protection against price erosion in later rounds. At the same time, however, the full ratchet protection will be unattractive to the potential investors in these later rounds, making an already difficult financing even more difficult for the company. It also exacerbates the dilution of the existing common stock. Full-ratchet price protection terms are fairly uncommon, and founders should push to have full-ratchet replaced by a weighted average formula.

Alternative 3:  No price-based anti-dilution protection.

This third alternative is the simplest of all – no price-based anti-dilution protection. Unfortunately, these are about as common as unicorns capering across my front yard.

Finally, there are some carve-outs that do not trigger anti-dilution adjustments.

The following issuances shall not trigger anti-dilution adjustment:

(i) securities issuable upon conversion of any of the Series A Preferred, or as a dividend or distribution on the Series A Preferred;

(ii) securities issued upon the conversion of any debenture, warrant, option, or other convertible security;

(iii) Common Stock issuable upon a stock split, stock dividend, or any subdivision of shares of Common Stock; and

(iv) shares of Common Stock (or options to purchase such shares of Common Stock) issued or issuable to employees or directors of, or consultants to, the Company pursuant to any plan approved by the Company’s Board of Directors [including at least [_______] Series A Director(s)].

These carve-outs are obviously different situations from where the startup has to do a down-round, and issues new preferred stock at a lower price than the existing preferred stock. Thank you for reading along with this math-heavy posting, and stay tuned for our next installments, which will cover pay-to-play and redemption rights.

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