Down-Round Anti-Dilution Protections grant its holder share price protection in the case where a later financing round is raised at a share price. The idea is to ensure that early investors don’t end up paying more for their shares than investors of later rounds, despite having taken on more risk. This is achieved by giving out additional shares depending on a predetermined formula: The full-Ratchet Formula or the more common and fairer Weighted Average Formula.
There are multiple ways to setup an anti-dilution protection clause. Either you can fully adjust the share price to the new, lower price or you find something “in between”. If you think about it, really lowering the early round investor’s share price exactly to the new price really isn’t the most fair or even beneficial approach. It could be hugely detrimental for founders and hence also to finding agreement on needed fund raises. If for example an Angel round holds 30% of shares already and the next financing comes in at a steep loss, that Angel round might end up with almost the entire company.
This so-called “Full-ratchet” method directly adjusts the share price of the entitled round to that of the new round. While generating an obviously unreasonable shareholding outcome, it would also eliminate any remaining motivation for the founders to continue to work for this company. So it would also destroy value for the Angel investors and usually is seen as not in the interest of investors either.
The Weighted Average Anti-Dilution Protection in contrast works with a formula that takes into consideration the size and prices of each round and the overall capitalization. That way it provides “some” adjustment, but not a full adjustment to the new price. Lets look at both methods in detail.
Full-Ratchet Anti-Dilution Protection
Again the Full-Ratchet Anti-Dilution Protection works by fully adjusting the entitle share class’ share price to that of the new financing round. That means, no matter whether a small US$50k short term bridge or a medium sized US$1m angel round is raised, the full adjustment is made. While investors might argue this to be fair as they had taken huge risk at an early stage with limited information, the outcome is very significant, independent of the exact circumstances. In contrast Founders would argue that part of trading higher returns for higher risk is also that an early investor might have overpaid and then can’t just ask for a rebate afterwards. In addition they would argue any price adjustment would have to be seen in perspective to the significance of the new round – meaning how large it is in comparison to the old round. Lets understand this with an example.
Example: Full-Ratchet Anti-Dilution Protection
Imagine you hold shares in a US$600k Angel round priced at US$200.00 which represented 30% of the shares at the time. Now the company is not quite ready to raise a Series A or even a regular sized Angel round. Instead a contact is willing to provide a bridge of US$200,000 at a share price of US$100. The Cap Table Prior without price adjustment would look as follows:
If you fully adjust the Angel share price down to US$100 you would have to double the Angel A rounds share number, significantly shifting company ownership. Suddenly, the Ordinary Shareholders (= Founders) have less than 50% of the company.
So even with such a small additional bridge amount, suddenly the two Angel rounds already own the majority of shares and the company is not even at Series A level. The Series A will take another 20-35% of shares and it might not be the last round. Independent of fairness, such developments are hugely detrimental to founder motivation. And founder motivation shouldn’t just matter to the Angel investors, but such a cap table will in fact be a deterrent to VCs.
Weighted Average Anti-Dilution Protection
A much more reasonable approach to deal with dilution in down rounds is the Weighted-Average Anti-Dilution Protection Method. It takes into consideration the past and current deal size and the overall the capitalization.
Weighted Average Anti-Dilution Protection Formula
The basic weighted Average formula reads as follows:
PA = Preference Amount
ESC = Existing Share Capitalization (=all shares outstanding before the new down-round. Either incl. All un-issued shares for broad-based or excluding these for narrow-based. See below for more details)
NSP = New Share Price (of the down-round)
NS = Amount of shares to be issued in down-round
NCP = New Conversion Price of Angel A after down-round
Broad-based vs. Narrow-Based
The weighted average formula can be calculated on a narrow or broad base of share capitalization. Both variants include all existing preferred shares as-if-converted, but the broad based variant also includes un-issued shares for outstanding warrants for example. Broad-based is the more common variant.
Lets see how our example above would fit into this formula, where a down round Angel B is raised and Angel A has a Broad-Based Weighted Average Anti-Dilution Protection.
PA = $200.00
ESC = 3,000
NSP = $100.00
NS = 2,000
NCP = to be calculated
This means 214 shares will be allotted to Angel A and the cap table would look as follows:
As you can see, while there was a significant price adjustment due to the down round, $186.67 is still far off from $100 under the full ratchet approach. Then again the new round is not that big in comparison to the existing capitalization of the company – only about 16%.
What factors would decrease the new conversion price even further? If the share price of the down-round (NSP) would be even lower or if the share issuance of the new round (NS) would be larger!
Advantages of Anti-Dilution Protections
Anti-dilution protections, at least the weighted average kind, are a meaningful tool to minimize early stage pricing uncertainty. In the initial Angel and even VC rounds, pricing of shares is much more of an art than a science. Nobody really knows, whether the right monetization strategy can be developed and whether the market responds positively. You might argue pricing risk has to be absorbed by an early stage investor. But see it this way: It is a tool that fosters greater investor confidence. It could help you close deals that might have not been able to be closed other wise.
Disadvantages of Anti-Dilution Protections
The downside of any anti-dilution protection is that it skews shareholder incentives and hence complicates any down-round fund raise. The shareholders suffering from it (usually founders) will have a strong incentive to limit such down rounds. This could cause them to raise not enough funds to weather the causes of the down-round.
Additionally, very aggressive anti-dilution protections can complicate future funding negotiations. Future investors might either want the same rights or require the previous rounds to have their rights weakened, if the new investors think it could jeopardize the prospects of the business.
What is reasonable?
From the above examples it should be very clear that Weighted-Average is the way to go. Full-Ratchet Anti-Dilution Protection and its variants should be avoided at all cost. Experienced Angels and professional Investors likely won’t even ask you for anything else but a Broad-Based Weighted-Average Anti-Dilution Protection. They just know how detrimental diverting terms will be for upcoming fund raises and internal votes.
Be aware that the investors who do consider asking for a Full-Ratchet formula likely won’t call it that. So you have to read the term sheet carefully. Think through whatever formula or text description is presented to you. Something like “In a down-round share prices will be adjusted to reflect the new round’s share price”. Sounds innocent enough, doesn’t? Weighted-Average it needs to be!
The Weighted-Average Anti-Dilution Protection is a common and reasonable protection mechanism that helps early stage investors get a reasonable price adjustment should later rounds be raised at a discount. Usually such down-rounds only happen, if the company is in dire straits or the original valuation was significantly too high. Given the higher uncertainty of early rounds it is reasonable to protect investors from some of the risk they are taking. Just avoid Full-Ratchet Anti-Dilution methods and their variants at all costs. They sound innocent, but can change majority positions in a single down-round and make follow-on investment more difficult.
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