Investors purchase equity securities of a company anticipating that the value of the company will increase. Sometimes, however, companies engage in so-called “down rounds,” which are subsequent rounds of financing in which they sell securities for less than the price paid for shares in earlier financing. In extreme cases, down rounds can result in substantial dilution to existing investors. Anti-dilution provisions protect investors from dilution in down rounds. This article provides an overview of the two basic types of anti-dilution protection in down rounds, which include “full ratchet” and “weighted average”. This article also discusses “structural” anti-dilution, which protects the holders of convertible securities from dilution upon structural changes to a company’s capitalization.
Down Round Protection
Full Ratchet Anti-Dilution.
If a company engages in a down round, the issue price of securities that have full ratchet anti-dilution protection is reduced to the lower price at which the new securities are sold, regardless of the number of new securities the company sells. As a result, the company must issue the protected investor an additional number of securities, so he holds the number of securities he would have received for the consideration he originally paid for his securities had the company issued such securities at the new lower issue price. As demonstrated in the example below, the application of full ratchet anti-dilution protection can have a significant accretive effect on the protected investor and an inequitable dilutive effect on the company’s existing shareholders. As a result, the existence of securities with full ratchet anti-dilution protection generally deters future equity investment into a company. Therefore, companies should grant full ratchet anti-dilution protection only as a last resort.
Weighted Average Anti-Dilution.
Weighted average anti-dilution protects investors in down rounds by increasing the number of securities to which the protected investor is entitled. It, however, employs a formula that takes into account the number of new shares being issued and the extent to which the new issue price is lower than the issue price of the protected securities. It, therefore, provides a dilution adjustment that is fair and equitable for both the protected investor and the existing shareholders. A typical weighted average anti-dilution formula decreases the effective price per share of the protected securities by multiplying it by a ratio, (A) the numerator of which is the number of common shares on a fully diluted basis outstanding prior to the new issuance, plus the number of common shares which the aggregate consideration received by the company for the new issuance would purchase at the effective price per share of the protected securities, and (B) the denominator of which is the number of common shares on a fully diluted basis outstanding prior to the new issuance, plus the total number of common shares issued or underlying the securities issued in the new financing.
Example.
The effect of the application of anti-dilution protection in a down round, and the inequity that can result from the application of full ratchet anti-dilution rather than weighted average anti-dilution is explained through the example below:
Assume a company has 9,000,000 common shares outstanding, and Investor A invests $1 million in exchange for a $1,000,000 convertible promissory note. Assume the note is convertible into 1,000,000 common shares at $1.00 per share, which represents 10% of the company’s outstanding common shares on a fully diluted basis. Assume the company is in desperate need of short-term capital and must raise $100,000 by issuing 1,000,000 common shares for $0.10 per share.
No Protection. If Investor A has no anti-dilution protection, the sale of 1,000,000 shares at $0.10 per share, would decrease his ownership interest on a fully diluted basis from 10% to 9.09%, and the ownership interests of the original shareholders would decrease from 90% to 81.82%.
Full Ratchet Protection. If Investor A has full ratchet anti-dilution protection, the sale of shares at $0.10 per share (regardless of the number of shares sold), would reduce the conversion price of his convertible note from $1.00 per share to $0.10 per share. Therefore, the common shares into which the note is convertible would increase from 1,000,000 to 10,000,000, resulting in an increase in the number of common shares outstanding on a fully diluted basis from 11,000,000 to 20,000,000. As a result, Investor A’s percentage ownership interest on a fully diluted basis would increase from 10% to 50%, and the ownership interests of the original shareholders would decrease from 90% to 45%.
Weighted Average Protection. If Investor A has weighted average anti-dilution protection, the sale of 1,000,000 shares at $0.10 per share, would reduce the conversion price of Investor A’s note from $1.00 to $0.9182, resulting in the note being convertible into 1,089,087 common shares rather than 1,000,000 common shares. As a result, Investor A’s percentage ownership interest on a fully diluted basis would decrease from 10% to 9.82%, and the ownership interests of the original shareholders would decrease from 90% to 81.16%, which is a much more equitable result than full ratchet protection.
The table below sets forth the capitalization of the company and the percentage ownership interests of Investor A, the down round investor, and the other shareholders, (a) before the down round, (b) after the down round assuming Investor A has no anti-dilution protection, (c) after the down round assuming Investor A has full ratchet anti-dilution protection, and (d) after the down round assuming Investor A has weighted average anti-dilution protection.
A detailed explanation of the weighted average anti-dilution formula and calculation as applicable to the above example is set forth at the end of this article.
Exceptions to Anti-Dilution.
In certain instances, it is not equitable or feasible to apply anti-dilution protection to diluting issuances, and companies should try to exclude such issuances from protection. These exceptions include, among other things, the issuance of a reasonable number of shares or options to management and employees, the issuance of shares upon the exercise of convertible securities outstanding prior to the issuance of the protected securities, and shares issued for consideration other than cash, which often occurs in mergers, acquisitions, strategic partnerships, and in the settlement of disputes. It is also a good practice for companies to include a provision providing that the holders of a majority of the protected securities can vote to exclude an anti-dilution adjustment in connection with specific diluting issuances.
Structural Anti-Dilution Protection
Structural anti-dilution provides an adjustment to the exercise or conversion price of securities convertible into common shares upon the occurrence of a subdivision, combination, stock dividend, reorganization, reclassification, or other event affecting the outstanding number of common shares. This type of anti-dilution protection ensures that investors holding convertible securities are treated as if they hold common shares, without having to convert their securities into common shares prior to the event and losing the features and protections associated with their convertible securities. For example, upon a 4-for-1 stock split, convertible securities would become convertible into 4 times the number of common shares (at the same aggregate conversion price), resulting in the convertible securities being convertible into the same percentage of the company’s outstanding common shares after the stock split.
Application of Weighted Average Formula.
The weighted average anti-dilution formula decreases the effective price per share of Investor A’s securities (“EP”) by multiplying it by a ratio, (1) the numerator of which is the number of common shares on a fully diluted basis outstanding prior to the new issuance (“X”), plus the number of common shares which the aggregate consideration received by the company for the new issuance would purchase at the EP (“Y”), and (2) the denominator of which is X plus the total number of common shares issued or underlying the securities issued in the new financing (“Z”). As set forth below, weighted average anti-dilution would result in Investor A in the prior example, being diluted down from 10% to 9.82%.
Under the prior example, the weighted average anti-dilution calculation would be as follows:
EP = $1.00
X = 10,000,000
Y = 100,000
Z = 1,000,000
EP x ((X+Y)/(X+Z))
or
$1.00 x ((10,000,000 + 100,000) / (10,000,000 + 1,000,000))
or
$1.00 x (10,100,000 / 11,000,000)
or
$1.00 x 0.9182 = $0.9182
Therefore, the EP or new conversion price of Investor A’s note would be $0.9182, resulting in the note being convertible into 1,089,087 common shares rather than 1,000,000 common shares. As a result, Investor A’s percentage ownership interest in the company would be diluted from 10% to 9.82%.
The information contained in this article is strictly for educational purposes and is not intended to be legal or tax advice or to be relied upon by anyone without doing their own research, and consulting with legal and tax advisors.