What Is a Price-Based Antidilution Adjustment?

by Scott Edward Walker on February 17th, 2011

Introduction

This post originally appeared as part of the “Ask the Attorney” series I am writing for VentureBeat.  Below is a longer version.  Please shoot me any questions in the comments section or, if you prefer confidentiality, via email at .

Question

My co-founder and I have a question regarding the term sheet we just received from a VC.  We don’t understand what a price-based antidilution adjustment is and what it’s meant to address.  The exact language under that section reads as follows: “Subject to standard and customary exceptions, the conversion ratio for Preferred Stock shall be adjusted on a broad weighted average basis in the event of an issuance below the Preferred Stock price, as adjusted.”  Could you please explain?  Thanks!

Answer

 

A price-based antidilution adjustment is a mechanism to protect investors in the event that the company sells securities at a price lower than the price of the securities purchased by such investors; it is complicated and can be devastating to the founders.

You first must understand that upon the issuance of preferred stock to an investor in a Series A round, the investor has the right (and the obligation, in certain instances) to convert the preferred stock into common stock, and conversion ratio is set at one-for-one.   The formula for determining the conversion ratio is (i) the original issuance price of the preferred stock divided by (ii) the conversion price (which originally is the price paid).

For example, assume that XYZ Inc. raises $2 million in a Series A round at an $8 million pre-money valuation, and the VC receives 2 million shares of preferred stock at $1 per share; the conversion ratio is 1 (1 divided by 1).  Now let’s assume a Series B round 18 months later in which XYZ raises another $2 million from a new VC, but at a pre-money valuation of $5 million.  Each share of Series B Preferred Stock is thus priced at $.50, and 4 million new shares must be issued to the Series B VC to raise the same $2 million.

XYZ thus issued twice as many shares in the down round to generate the same amount of cash.  As a result, the Series A VC’s ownership is diluted (so are the founders!), and this is what a price-based antidilution adjustment is designed to address.  The position of the Series A VC is that it valued the company too high and therefore should be able to “recover” its overpayment by adjusting the conversion ratio.

There are two basic types of price-based antidilution adjustments: (i) “full ratchet” (or “ratchet”) and (ii) “weighted average.”

Full Ratchet.  A full ratchet antidilution adjustment is draconian to the founders (and other holders of the company’s common stock) and thus is relatively rare.  This type of adjustment “ratchets” down the conversion price to the lowest price at which stock is issued after the issuance of the investor’s preferred stock – regardless of the number of shares issued.  In the example above, the conversion price would be $.50, the conversion ratio would be 2 (1 divided by .50), and the Series A investor would receive twice as many common shares upon conversion.  Note that the same conversion ratio would result even if the company issued just one share for a price of $.50.

Weighted-Average.  By use of complicated formulas, a weighted-average antidilution adjustment takes into account both (i) the lower price and (ii) the actual number of shares issued in the down round; it is therefore more moderate and indeed more accurately reflects the dilutive effect.  Accordingly, the greater the number of shares that are issued at a lower price the more significant the adjustment to the conversion ratio.

There are two categories of weighted-average formulas: broad-based and narrow-based.

In a broad-based weighted-average formula, the dilutive issuance is weighted against the fully diluted capital stock of the company (i.e., it assumes conversion of all preferred stock, warrants, stock options and other convertible securities).  In a narrow-based weighted-average formula, the dilutive issuance is only weighted against the outstanding securities and does not include convertible securities. A broad-based formula thus compares a dilutive issuance to a larger pie making the issuance appear less significant and therefore more appealing to the founders.

Conclusion

Based on the foregoing, the language in your term sheet (i.e., “adjusted on a broad weighted average basis”) is generally the best you’re going to get with respect to this issue.  Good luck.

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