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50 Questions: What is anti-dilution/downround protection?

Thirty-fourth in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital.  We expect the series to run for a year after which we will collate the posts into a book.  You can find the rationale behind the series here, and the list of questions here.  We welcome your comments on any and every aspect of what we are doing.

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In my post Key terms in a termsheet Part 2 I covered the basics of anti-dilution.  In that post I wrote:

Anti-dilution is a term which compensates the investor if there is a subsequent round of investment done at a lower share price, often called a down-round.  The mechanism by which it works is a retrospective adjustment of the share price so that the investor gets more shares and it is as if they they had originally invested at a lower share price.

There are three flavours of anti-dilution to be aware of:

  • full ratchet anti-dilution, in which the investors share price is adjusted all the way down to the share price of the new round
  • narrow-based weighted average anti-dilution, in which the investors share price is adjusted part way down to the share price of the new round depending on a formula which considers the amounts invested
  • broad-based weighted average anti-dilution, which is like narrow based, but reduces the share price slightly less, thus favouring the entrepreneur

Full ratchet anti-dilution is very favourable to the investor and most termsheets have one of the two weighted average formulas, with broad based being the most common.

In this post I’m going to go into a little more detail on each of the three mechanisms.  The most important part of the anti-dilution clause is usually expressed as a mathematical formula which determines how many extra shares the investor will get if there is a new round at a lower share price, or sometimes how the conversion ratio from preferred to ordinary will be adjusted to deliver the same economic result.  (Extra share formulas are more common in Europe whereas in the US it is more common to adjust the conversion rate.)  I will show a typical formula for each type of anti-dilution and provide a worked example.

The maths gets a little heavy, so you may want to save this until you have a real life situation to deal with.  The take-away from a negotiation perspective is that the difference between narrow-based and broad-based anti-dilutino is minimal when compared with the difference to full-ratchet.

For each of the formulas below:

  • N = number of new shares to be awarded
  • Op = old share price
  • Np = new share price in the dilutive round
  • S = number of shares currently held by investor
  • Wp = Weighted average share price
  • Stot = total number of shares in issue prior to the dilutive round (i.e. excluding options)
  • Snew = number of shares being issued in the dilutive round
  • Soptions = number of options

Full ratchet

Formula: N = S*Op/Np – S

In a real world example, if the Series A was £1m on £3m pre-money/£4m post money and the share price was £1 per share then there would be 4 million shares in issue after the round of which one million would be owned by the investor.  If the Series B was £0.5m at a £2m pre-money valuation, dividing the new valuation into the number of shares tells us the new share price would be 50p (2m/4m=0.5).

Plugging these numbers into the anti-dilution formula:

  • Op = 1
  • Np = 0.5
  • S = 1,000,000

and therefore N = 1,000,000*1/0.5 – 1,000,000 = 1,000,000

In other words the investor would get the same number of shares again (which is what you’d expect given that the she is being fully compensated for a halving of the share price.

Putting that into pre-option pool percentage terms the investor before the dilution from the new money would go from having 25.0% (1m/4m) to 40.0% (2m/5m), and all the other shareholders would suffer the reverse – dropping from 75% to 60%.  Of course, given that all this is happening at the same time as a new investment the investor would never actually own 40% of the company.  The percentage she ends up with would depend on how large the round is and how much of it she invested.  If she didn’t contribute at all to the £0.5m Series B then her stake after the round would be 32.0%.

Weighted average: narrow-based

Weighted average anti-dilution takes into account the dilutive impact of the down round so that the investor isn’t overly compensated if the down round is only a small one.  The mechanic of this is to use the weighted average share price in place of the new share price.

Formula: N = S*Op/Wp – S

Where: Wp = (Op*Stot + Np*Snew)/(Stot + Snew)

Using the same rounds as in the previous example the numbers in the equation are:

  • Op = 1
  • Np = 0.5
  • S = 1,000,000
  • Stot = 4,000,000
  • Snew = 1,000,000

Note: Snew was calcluated by dividing the £0.5m Series B investment into the 50p new share price – 500,000/0.5 = 1,000,000.

So Wp = (1*4,000,000 + 0.5*1,000,000)/(4,000,000 + 1,000,000) = 0.90

and therefore N = 1,000,000*1/0.9 – 1,000,000 = 111,111

So in this example the investor gets only 111,111 shares in compensation – much less than the 1,000,000 she would have got with full ratchet protection.

Putting that into pre-option pool percentage terms the investor before the dilution from the new money would go from having 25.0% (1m/4m) to 27.0%% (1.111m/4.111m), and all the other shareholders would suffer the reverse – dropping from 75% to 73%.  If she didn’t contribute at all to the £0.5m Series B then her stake after the round would be diluted by 20%, falling to 21.6% (0.8*27%).

In other words, narrow-based weighted average protection is significantly worse for the investor than full ratchet.

Weighted average: broad-based

Broad-based weighted average anti-dilution protection differs from narrow based only in that it takes into account any options that have been issued.  (Options are not considered in the narrow based calculation.)  The mechanic of this is to adjust only the calculation of the weighted average share price, leaving the other part of the formula the same.

Formula: N = S*Op/Wp – S

Where: Wp = (Op*(Stot + Soptions) + Np*Snew)/(Stot + Soptions + Snew)

If the option pool before the new round was 10% then the number of options would be 444,444.

Sticking with the same rounds the numbers to plug into the equation are:

  • Op = 1
  • Np = 0.5
  • S = 1,000,000
  • Stot = 4,000,000
  • Snew = 1,000,000
  • Soptions = 444,444

So Wp = (1*(4,000,000 + 444,444) + 0.5*1,000,000)/(4,000,000 + 444,444 + 1,000,000) = 0.91

and therefore N = 1,000,000*1/0.9 – 1,000,000 = 101,124

Putting that into pre-option pool percentage terms the investor before the dilution from the new money would go from having 25.0% (1m/4m) to 26.8%% (1.101m/4.101m), and all the other shareholders would suffer the reverse – dropping from 75% to 73%.  If she didn’t contribute at all to the £0.5m Series B then her stake after the round would be diluted by 20%, falling to 21.5% (0.8*26.8%).

This is marginally worse for the investor than narrow based, but there isn’t much in it.  With larger option pools the difference increases rising approximately in line with the increase in option pool, but the difference between broad-based and narrow-based weighted average anti-dilution is always going to be much less than the difference to full ratchet.

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  • http://twitter.com/davidsmuts David Smuts

    I always knew you were a Mathematician at heart Nic! Well done and thanks for diving into the detail for us in this- keep sharing :-)