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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Anatomy of a Term Sheet 2 – Pre-Money Valuation and the Option Pool

Welcome to Anatomy of a Term Sheet Part Two.

In the first part, we looked at the introductory language and some of the basic offering terms in the model term sheet of the National Venture Capital Association, which you can find here.

Today we are going to look at two remaining basic offering terms – price per share, and pre-money valuation. The pre-money valuation term raises a very important issue for founders, involving the employee option pool and the dilutive effect this term will have. So join me as we dig in… 

The first term to examine in this part is:

Price Per Share: $[________] per share (based on the capitalization of the Company set forth below) (the “Original Purchase Price”).

This is the price that the VC investors will be paying for each share of preferred stock. If there are angel investors who put in money through a convertible note, they will probably be paying a lower price per share when converting the loan to equity, due to price discount and valuation cap terms in the convertible note financing.

The next term, which is a crucial one to understand, involves pre-money valuation and the employee option pool:

The Original Purchase Price is based upon a fully-diluted pre-money valuation of $[_____] and a fully‑diluted post-money valuation of $[______] (including an employee pool representing [__]% of the fully‑diluted post-money capitalization). 

The pre-money valuation is the valuation immediately prior to the VC investment, and the post-money valuation is the pre-money valuation plus the amount of the investment. So, if the pre-money valuation is $4 million, and the VC is investing $2 million, the post-money valuation is $6 million.

Note the use of the term “fully-diluted” in connection with the pre-money valuation, post-money valuation, and post-money capitalization. “Fully-diluted” means the highest potential amount of common stock that could be outstanding, regardless of vesting and assuming that all options and other securities (such as convertible notes) are converted into common stock.

The inclusion of the employee option pool in the post-money valuation and capitalization has the effect of diluting the founders’ share of the startup, without diluting the VC investors’ share. To see how this works, let’s return to the scenario just described, where the pre-money valuation is $4 million, the VC investment is $2 million, and the post-money valuation is therefore $6 million.

Assume there are two founders, each with 50% of the stock pre-money, and there is no option pool. Thus, prior to the VC investment, the founders owned 100% of the company, collectively. After the investment, if there is still no option pool, the VC fund will own 33% ($2 million divided by $6 million) and the founders’ stake will be reduced to 66%.

As a practical matter, however, the VC will require the startup to set up an employee stock option plan and set aside an option pool for the employees. Startup companies are typically short of cash, and the stock option plan is an important tool for attracting and retaining talented employees, and giving them an opportunity to share in the increasing valuation of the startup.

When the VC uses the above language to require an option pool, it is taking that option pool out of the founders’ share, further diluting the founders, but not diluting the VC. To determine the price per share, the post-money valuation is divided by the fully-diluted number of shares outstanding, plus all the shares or options that will be issued in the future as part of the option pool.

Let’s take a second look, assuming the option pool is 20% of the fully-diluted post-money capitalization (20% is a fairly common size for option pools). Now the cofounders only own 46% of the post-money company (66% minus 20%), while the VC investor still owns 33%. The founders’ share of the company has been diluted, but the VC’s share has not. The founders’ ownership has decreased by 30%, all due to that “post-money capitalization” language.

What can the founders do to avoid or mitigate the dilution that is caused by the option pool? As a practical matter, a startup will not be able to have the VC’s remove the option pool requirement, and that isn’t a good idea anyway. As I mentioned before, stock options are an important tool for attracting and retaining good employees, especially when the company is cash-poor. Stock options are desirable, it’s the dilution of the founders that is problematic. Unfortunately, founders also will not be able to get the VC’s to share in the dilution alongside the founders. The VC’s have the upper hand here, because they have the money. There are a few partial remedies that are possible.

The first remedy is to negotiate for a higher pre-money valuation, to compensate at least in part for the option pool dilution. Going back to the previous example, let’s suppose the pre-money is $5 million, with the VC’s investing $2 million. The post-money is now $7 million. The VC’s share of the post-money capitalization is 29%. The founders’ share is now 51% (taking into account the 20% option pool), which is better than the 46% share when the pre-money was $4 million.

A second remedy is to try to reduce the size of the option pool as much as possible. If your startup already has an executive team in place, you might be able to get away with a 10% option pool; you don’t need the extra options to entice a CEO or other top executives.

A third remedy is to already have the option plan and pool in place before going to the VC investors. Whether this is possible will depend on where the startup is in its development process, as well as the finances of the startup. Setting up a stock option plan will cost about $1500 to $2000 (maybe more, maybe less), and if the startup has money available from an angel investment, it may be a good use of funds. The stock option plan will make it easier for the startup to attract employees at this stage, allowing it to stretch its funds a bit further. And if the plan is already in place, the VC’s may not push as hard on the size of the option pool.

Hopefully this helps to explain a fairly complex yet common issue that arises when negotiating with VC investors. Next time, I will write about the alternative provisions for dividends.

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