In our previous post on venture capital term sheets, we looked at the basic structure of an investment. In this post, we take a closer look at one commonly negotiated part of a term sheet, the anti-dilution provision.
Let’s say a venture capitalist (“VC”) owns 20 shares out of a company’s total 100 shares. This gives them a 20% ownership stake in the company. If the company then issues 100 new shares, the VC now owns 20 shares out of 200 shares, or 10% of the company. All else equal, this dilution effectively reduces the VC’s control over the company.
This is usually not a problem if the new issuance is at a higher price than the VC originally paid for their shares, since it means their shares are worth more — yes, they have a smaller slice, but it’s a bigger pie. However, if the company is not doing as well as expected and ends up issuing new stock at a lower price (known as a “down round“), then original VC’s shares will be diluted, or worth less than they paid for them.
The anti-dilution provision of a term sheet is designed to protect investors from dilution in a down round, either by issuing them additional shares or, much more commonly, lowering the conversion price of their existing preferred shares so that each preferred share can convert into more common shares. As a result, anti-dilution comes at the expense of the company’s common shareholders — including the founders and perhaps some employees — because in order to reduce the VC’s dilution, they increase their own.
Anti-dilution provisions come in two varieties, each which reflects a different formula for calculating the value of the stock after a new round of investment: weighted average and full ratchet.
Full ratchet is worse for the founder than weighted average. It sets the conversion price of the VC’s existing preferred shares in relation to the price of the new round of shares, regardless of how many new shares are issued.
Full ratchet is worse for the founder than weighted average. It sets the conversion price of the VC’s existing preferred shares in relation to the price of the new round of shares, regardless of how many new shares are issued. As a hypothetical, say in the last round of financing a VC paid $1 each for 100 preferred shares. In the new round, the company just needs a little cash, so is issuing just one share, for $0.50. In a full ratchet scenario, the issuance of that single share will lower the conversion price of each of the VC’s existing 100 shares from $1 to $0.50. The VC, in other words, can now convert to twice as many common shares as before. As a result, the common shareholders are significantly diluted just because they issued a single new share.
The weighted average approach to anti-dilution is more moderate and reasonable, and better for the founder, than full ratchet. Unlike full ratchet, weighted average employs a formula that takes into account not only the share price of the new issuance, but also the number of shares issued, so that if, as in the above example, only a small number of shares are issued in the new round, the adjustment to the conversion price is also small. Fortunately for founders, the weighted average approach is more commonly used than full ratchet.
There are two types of weighted average anti-dilution provisions, broad-based and and narrow-based. The difference between the two is which shares they take into account. Broad-based takes into account shares that narrow based does not, including shares that have not yet been converted (for example, outstanding employee options). Using a broad-based weighted average is more favorable to the founder because it results in a higher conversion price for the VC.
Founders can offset the effect of unfavorable anti-dilution terms by negotiating for pay-to-play terms, which require a VC to participate in a future round of financing in order to receive anti-dilution protection. In other words, the VC has to commit more capital to the company in order to get the benefit of anti-dilution.
Anti-dilution provisions can be complicated and math-intensive, and when you’re negotiating them with an investor it’s important to have the help of a qualified attorney. But familiarizing yourself with the concepts and knowing your options are will go a long way towards helping you negotiate confidently.
In our next post in the series, we’ll look at two other common term sheet components, liquidation preferences and participation.