Startup 126: Term Sheet – Anti-Dilution

This is the third post in a series attempting to demystify venture capital term sheets.  The first two posts are on Valuation and Liquidation Preferences and are a good place to start.

Delusional on Dilution
As mentioned in the previous posts, a venture capital (VC) term sheet is a non-binding letter of intent that outlines a potential investment in a startup.  Much of what a term sheet covers is the value of the company and how much ownership the founders and other shareholders give up in order to get the investment.  The amount of ownership a company gives up is called dilution.  And between valuation discussions, liquidation preferences and especially with the math for anti-dilution, this whole process might start to make you a little delusional.  But hang in there, as this is the last big term dealing with dilution.

What’s the Big Idea?
In addition to giving up a stake in the company, when you raise venture capital, investors typically get additional protection rights that, in certain cases, their ownership stake will not be diluted.  This primarily deals with the case when a future investor gets a better price to invest in the company.  The term is referred to, as you already guessed, Anti-dilution.

Anti-dilution is a price protection guarantee not unlike, for example, when a store like Best Buy guarantees it will make up the difference on the price you pay for a camera if you find it for a lower price later. In reality, you only have to worry about this term if you have a down round.  A down round is when a follow on investment is made at a pre-money valuation that is lower than a previous round’s pre-money valuation.  (Don’t know what pre-money means, then check out the post on Valuation.)

As a result, based on how well you execute you have lots of control to avoid having investors ever use this protection.  (See previous post Control Freaks are Us). Plan, execute and deliver results and odds are that even in tough times your valuation will increase from each round. But let’s look at how this works in the case you do have a down round.

How it works
As mentioned earlier, Anti Dilution is basically price protection for the investors.  Let’s go back to the example used in the previous two posts in which NewCo, Inc. sells shares in a Series A investment at a pre-money valuation of $6 million and raises $4 million of new money. If there were 6 million shares (4 million for the founders and employees plus 2 million for a 20% option pool), that would price the shares at $1 per share ($6 million/6 million shares).  By raising $4 million, NewCo, Inc. issues 4 million new shares at $1 per share to the investors for a total of 10 million shares.

Following so far?  I hope so because that’s the easy math!

Let’s say for some reason that disaster strikes and NewCo misses most of its goals, the economy goes into recession, and yet the company needs to raise more money.  NewCo, Inc. gets an offer from a new investor to provide $1 million for a Series B at a $5 million pre money valuation.  Since the post money of the Series A was $10 million and the pre-money of the Series B is $5 million, this is referred to as a down round. In this case, the Series A Anti-dilution protection would kick in.

There are two types of Anti-Dilution preferences – Weighted Average and Full Ratchet.  Let’s start with the most common, which is a weighted average formula called “Broad based weighted average”. According to Wilson Sonsini, a leading Silicon Valley law firm, 92% of their term sheets in 2008 used Broad-based weighted average.  And that’s good news, because it is the most favorable for the company other than not having any Anti Dilution which is probably not going to happen for most companies.

So what happens?
Basically, Anti-dilution lowers the price at which preferred shares convert to common stock.  As mentioned in the previous post on Liquidation Preferences, in the case of a sale or an IPO that exceeds the minimum liquidation preferences, preferred shares convert into common stock.  In the case of Anti-dilution, when the conversion happens, the preferred shares convert at lower price so that preferred shares receive extra shares of common stock as their price protection.

In the case of broad-based weighted average, the idea is to lower the original conversion price to a number somewhere between itself and the new price per share based on a weighted average of the shares issued in the down round and the number of shares that would have been offered if the round had been at the price of that investors round.

And now for the fun part – Algebra.

The formula to calculate the conversion rate is:

((Fully Diluted Shares pre-down round + Shares issuable if investment had been at higher round price) / (Fully Diluted Shares pre-down round + Actual shares issued in down round)) * Original Conversion Price

In our example of NewCo, Inc, the new conversion factor is calculated as follows:

(10,000,000 shares + 1,000,000 shares)/(10,000,000 shares + 2,000,000 shares) * $1  = $.92

• The 10,000,000 shares is Fully Diluted Shares following the Series A, all common shares help by founders and employees, all allocated in the option pool and all preferred shares help by investors.
• The 1,000,000 shares issuable is calculated based on if the investment had occurred at the Series A price by dividing the $1 million new investment by the Series A price per share which was $1.
• The Actual shares issued in the down round are calculated by determining the price per share ($5,000,000 pre-money valuation divided by 10,000,000 shares outstanding) of $.50 and then dividing the investment amount by the price per share ($1,000,000/$.50) which equals 2,000,000 shares issued in the down round.
• The $1 is the Series A price per share and conversion price.

As a result, the 4 million Series A preferred shares would eventually convert by dividing the total numbers of shares by the new conversion price.

4 million shares / .92 =  4,363,636 shares.

The 363,636 additional shares is the result of the Anti Dilution protection for the series A. In summary, the idea for a broad based weighted average anti-dilution is that investors get some protection based on the weighted average of all the shares in the company on a fully diluted basis.  Of all the alternatives, this is the most reasonable and desirable for the company.

What are the Twists?
First, if there is more than one round of funding prior to a down round, then each round would go through a similar calculation.  The difference being the “Shares issuable if investment had been at higher round price” uses the price for each round.  This is not really a twist but causes further dilution as each round gets a new and lower conversion price.

Secondly, you will sometimes see something called “Narrow-based” weighted-average.  These are far less typical and the difference is basically that it excludes unexercised options, warrants and the like.  As a result, the new conversion rate is lower and more favorable to investors than broad-based weighted-average formulas.

Lastly, there is the dreaded Full Ratchet.  This is much simpler to explain yet thankfully in only about 5% of all term sheets though it was in 10% of 2008 down round term sheets (Again all data from Wilson Sonsini).   How this works is that the lower price of the down round simply becomes the new conversion price.  In our example, the Series A investors would convert at $.50 per share instead of $1.  This means they would end up with 8 million versus the 4.3 million shares under the broad based weighted average.  (4 million shares divided by .5) Clearly this is painful and it’s not that common because it dilutes the founders and employees to a point, that it’s not in their interest to stay for the long term as their stake is no longer meaningful.

Additionally, the earliest investors avoid using this because it may never benefit them and if the down round is higher than the Series A price, it may only cause dilution for themselves.

Summary
This has been a long post with lots of math so thanks for hanging in there.  In summary, most every term sheet has Anti-dilution.  If you can, focus on getting a broad based weighted average formula and then make sure you execute well so that this never comes into play.

(UPDATE: Posted the next in the series Startup 127: Term Sheet – Voting Rights and Protective Provisions)

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More info and References

• Startup 124: The Term Sheet – Valuation and Dilution
• Startup 125: Term Sheet – Liquidation Preferences
• Download sample Term Sheet from National Venture Capital Association
• Wilson Sonsini Term Sheet Metrics
• Rachet and Clank picture copyright Sony Computer Entertainment