What are carveouts to anti-dilution protection?

August 4, 2007

A company will want to ensure that certain types of stock issuances do not trigger anti-dilution protection.  This is especially true with full-ratchet anti-dilution protection because the issuance of even 1 share at a price lower than a series of preferred stock will result in an adjustment of the conversion price of all shares of that series of preferred stock.

A list of company-favorable carveouts to anti-dilution protection from a term sheet may include:

There will be no adjustment to the conversion price for issuances of (i) shares issued upon conversion of the Preferred; (ii) shares or options, warrants or other rights issued to employees, consultants or directors in accordance with plans, agreements or similar arrangements, but not to exceed a total of [__________] shares issued after the closing date [or such greater number as unanimously approved by the board]; (iii) shares issued upon exercise of options, warrants or convertible securities existing on the closing date; (iv) shares issued as a dividend or distribution on Preferred or for which adjustment is otherwise made pursuant to the certificate of incorporation (e.g., stock splits); (v) shares issued in connection with a registered public offering; (vi) shares issued or issuable pursuant to an acquisition of another corporation or a joint venture agreement approved by the board; (vii) shares issued or issuable to banks, equipment lessors or other financial institutions pursuant to debt financing or commercial transactions approved by the board; (viii) shares issued or issuable in connection with any settlement approved by the board; (ix) shares issued or issuable in connection with sponsored research, collaboration, technology license, development, OEM, marketing or other similar arrangements or strategic partnerships approved by the board; (x) shares issued to suppliers of goods or services in connection with the provision of goods or services pursuant to transactions approved by the board; or (xi) shares that are otherwise excluded by consent of holders of a majority of the Preferred.

Investors and the company will argue about the scope of the carveouts and potentially the number of shares in any given careveout.  In order for some of the carveouts to apply, the investors may require that the issuance of stock be unanimously approved by the board or approved by the directors nominated by the preferred stock.

A company generally wants flexibility in the carveouts to avoid anti-dilution protection being triggered and bothersome amendments to the certificate of incorporation to waive anti-dilution adjustments.  Although an anti-dilution adjustment may be waived by a specific shareholder, I’m not sure the waiver would be valid against a subsequent holder of the shares that did not know about the waiver.  Therefore, a properly drafted certificate of incorporation should allow for the waiver of an anti-dilution adjustment upon a certain vote of the preferred stock or applicable series of preferred stock, without the need to amend the certificate of incorporation.