In the last few posts, I have covered Term Sheets and detailed some of the terms that should stand out to VCs and founders. This week, we will dive into Anti-Dilution provisions in the Term Sheet, what Anti-Dilution is, and how various conditions can affect the economics of startup financing and equity ownership of a startup.
What is Anti-Dilution?
Anti-Dilution provisions are clauses written in a Term Sheet that protect investors from diluting their equity ownership under specific circumstances. Maintaining equity ownership is essential for several reasons. An equity stake in a company determines the size of a return during a liquidity event. Beyond that, equity ownership often determines voting rights and board seats, affecting an investor’s control over the company. It’s in the VC’s best interests to maintain equity in their portfolio companies; therefore, Anti-Dilution clauses are standard. Typically, these clauses will come into play during a “down round” of financing, which I will touch on below. Remember, when VCs invest in a startup, they receive Preferred stock, while other equity holders have Common stock. An investor’s shares will convert to Common stock (or take advantage of their Liquidation Preference) at a liquidity event. Often shares convert 1:1, where one share of Preferred becomes one share of Common. With Anti-Dilution provisions, investors aren’t granted more shares, but instead, their conversion ratio changes.
Although technically not found under Anti-Dilution in the Term Sheet, we should still discuss what Pro-Rata is. Derived from the Latin phrase meaning “in proportion to,” a Pro-Rata clause gives the investor the right, but not the obligation, to purchase shares in a future financing round to keep their proportion of equity ownership in a company. Given that each financing round will inject more capital into a startup at a higher valuation (in an ideal scenario), dilution is a standard part of the startup financing process. VCs and founders want to own a smaller piece of a bigger pie. With Pro-Rata rights, an investor has the option to maintain his or her size of the pie by having the opportunity to buy that proportional number of shares in future rounds. This clause can either be found on its own or found under the “Right of First Refusal” clause on a Term Sheet. In any case, it is a form of Anti-Dilution for an investor and is appropriate to cover here. To read more on this subject, I highly recommend Fred Wilson’s blog post on it.
How Anti-Dilution Works
Back to down rounds. A down round is a funding event that occurs when a startup’s valuation is lower than the previous funding round’s valuation. For example, if a startup raises a Series A financing at a $10M valuation, and then 18 months later raises a Series B financing at a $7M valuation, Series B will be a down round. In this situation, the Series B investor will get a significantly lower price per share for their investment than the Series A investor did, thus diluting the Series A investor. In a scenario such as this one, the Anti-Dilution provisions kick in. There are three different types of provisions:
No-Priced Based Protection: This clause means there is no protection. In the event of a down round, the investor carries the full risk of having their proportional stake reduced on an unconverted basis, along with the Common shareholders. From the perspective of Common shareholders (founders), this is the fairest position. Investors likely won’t risk their Preferred shares, so this clause is rare.
Full Ratchet: This clause is the most straightforward conversion but also the most dilutive to Common shareholders. In this scenario, all of an investor’s existing shares convert at the new price per share. For example, if a Series A investor bought 1,000,000 shares at $1/share, but the down round Series B price per share is $0.50 at the new, lower valuation, then the Series A investor’s shares will now be worth $0.50. This example effectively doubles the Series A investor’s ownership at conversion because their original investment of $1,000,000 would have bought 2,000,000 shares at $0.50/share vs. 1,000,000 shares at $1/share. At a liquidity event, the Series A conversion rate will be 1:2 from Preferred to Common. Full Ratchet is very aggressive and is not a founder-friendly term, so it’s not as common as Broad-based protection.
Broad-Based Protection: A more reasonable method for handling dilution is the “broad-based” or “weighted average” method. In NVCA’s Model Legal Documents, their Term Sheet provides a straightforward formula for calculating this:
CP2 = CP1 * (A+B) / (A+C)
CP2 = Conversion price immediately after the new issue (Series A new price, what we’re trying to solve)
CP1 = Conversion price immediately before the new issue (Series A original price)
A = # of shares of Common stock deemed outstanding immediately before the new issue (shares outstanding at Series A)
B = The total investment received by the company for the new issue divided by CP1 (Basically, however much money is being invested at Series B divided by the Series A original price)
C = # of new shares of stock issued (How much stock issued at Series B)
Here’s a quick example of Broad-based protection: A startup has 1,000,000 Common shares outstanding and then issues 1,000,000 shares of Preferred stock in a Series A offering at a purchase price of $1.00 per share. The Series A stock is convertible into Common stock at 1:1 for a conversion price of $1.00.
18 months later, the company conducts a Series B financing, offering an additional 1,000,000 Preferred stock shares at $0.50 per share, a down round. We calculate the new conversion price for the Series A shares as follows:
CP2 = $1.00 x (2,000,000 + $500,000) / (2,000,000 + 1,000,000) = $0.83
The Series A shares now convert into 1.2 shares of Common.
Original Price $1.00 / New Price $0.83 = 1.2
Anti-Dilution provisions are typically standard in Term Sheets and can seriously affect equity ownership. The unfortunate reality is that the founders and other holders of Common Shares suffer the most dilution during a down round when these provisions kick in. Full Ratchet clauses are too dilutive and are a bit of an overreaction, so founders should negotiate against them. Broad-based is much more founder-friendly and, therefore, much more common.