First Post by Sara Rodriguez-Lopez

For those (many) who don’t know me, I moved a few months ago to Denver where I began to volunteer at the Rockies Venture Club. After only 3 months I met a lot of interesting people and learned about so many different things that my head was ready to explode!

I earned my Master’s in entrepreneurship and I did start my own company in the past, but it was at RVC where I got to see, for the first time, how Angel investors work. Eventually, I thought “Ok, I got it! I’m starting to see the big picture” until Nicole Gravagna invited me to Pat Linden’s Anti-dilution class!

Anti-dilution, now that’s tricky stuff!

A couple of days before the class I started reading about anti-dilution… oh boy!!! Full ratchet, narrow weighted average, broad weighted average, pay to play…This stuff really made my head spin…  At the end, I think I ended up having a “more or less” clear picture about the anti-dilution provisions… So, here I am writing down what I learned (just the basics… very basic) and hoping this blog-post would help someone out!

 

What is dilution?

Dilution is the subsequent sale of shares of stock at a price per share less than that paid by the preceding investor. Therefore, to protect their rights investors usually include an anti-dilution clause in the term-sheet.

If you are an investor you may be wondering now: why when the shares are sold at a higher price it’s not considered dilution if my ownership percentage will be reduced?  Because, although it is true your ownership is being diluted, the increment on the share price implies that the valuation of the company went up. As a result, the overall value of your investment increased and you should be happy. Cool! First thing clear!

 

What mechanisms can be put in place to avoid investment dilution?

There are two main formulas:

A. Weighted Average Formula: is the most common approach to anti-dilution protection and calculates the price considering the price and the amount of money previously raised as well as the price and amount of money being raised in the subsequent dilutive financing.

There are two primary variations of this formula that are basically differentiated by what constitutes “issued and outstanding common stock”

a.1) Broad based: the term “issued and outstanding common stock” includes all shares of stock outstanding, common and future stocks.

  • For Founders: This is the anti-dilution clause more “company friendly” and also the most customizable one, many investors will agree upon this formula.

a.2) Narrow based: the term issued and outstanding common stock” includes only the common stock issuable upon conversion.

  • For Investors: Narrow based is the most beneficial for you since this formula provides a higher conversion rate than the broad based.

B. Full Ratchet: “when the conversion price of the preferred stock outstanding prior to such financing is reduced to a price equal to the price per share paid in such a dilutive financing” or in other words: if you bought a share per $1 and the new price is $0.5 the conversion rate is two. For each of the “old” shares you get two of the “new ones”. Under this formula it doesn’t matter if the company raises $20,000 or $200,000,000

  • For Founders: awful, no matter how you look at it you don’t want to be here (it seriously jeopardizes your ability to raise money from new investors).
  • For Investors: it is a great deal and the most protective clause you can get, but be careful in this way you can lock down the company to future investors.

 

Is there something the company can do to mitigate the cons of an anti-dilution provision?

One of the most common clauses that companies usually include in the term sheet in order to protect their rights is the “Pay To Play”  clause that provides anti-dilution protection only for investors who will participate in the next dilutive finance. With this formula the founders incentive their investors in keeping on investing in the company and therefore, avoid some the major problems of the Full Ratchet (It can also be incorporated in the Weighted Average Formula).

 

Is there something else that helps reducing the dilution risk?

Yes, having the “right valuation” can be, for both the entrepreneur and the early investor, the best measure against dilution. Why is that? Well, the answer comes easy, having a feet-on-the-ground valuation will avoid the issuance of future stock at a lower price as well as will save money in lawyers exercising crazy clauses in crazy terms sheets. I know, valuation is hard but definitely something worth spending some time on.

 

There isn’t a better contract than the one based on trust and transparency

Founders: the Investor is now part of your team (and you aren’t giving anything away).

Investors: the founders love the company and more than anyone they want the company to succeed… they don’t want to run with your money away!

Guys, let’s work together!!

 

So…I started writing this post for my own sake, it isn’t perfect and it doesn’t cover all the points but I think now I really understand what is anti-dilution and hopefully you do too.  Now time for a “fat tire”! Hope you enjoyed your reading 🙂

 

Further information at: http://www.stanford.edu/class/e145/2008_fall/materials/The%20Venture%20Capital%20Anti-Dilution.pdf

6 replies
  1. joaquin
    joaquin says:

    Do you have any idea of until when can you exercise antidilution rights? Once a downround is closed can they still be claimed/exercised? Is there any time limit? Can they be acumulated? Thanks

    Reply
    • Ian
      Ian says:

      Antidilution usually kicks in as soon as the round closes and should happen automatically as a part of your rights as a previous investor. Yes they can be accumulated, at every down round you the antidilution rights will kick in.

      Reply

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