What is weighted average anti-dilution protection?

August 4, 2007

The most common anti-dilution protection is called “weighted average” anti-dilution protection. This formula adjusts the rate at which preferred stock converts into common stock based upon (i) the amount of money previously raised by the company and the price per share at which it was raised and (ii) the amount of money being raised by the company in the subsequent dilutive financing and the price per share at which such new money is being raised. This weighted average price (which will always be lower than the original purchase price following a dilutive financing) is then divided into the original purchase price in order to determine the number of shares of common stock into which each share of preferred stock is then convertible, which will be greater than one. Thus, a new reduced conversion price for the preferred stock is obtained, which results in an increased conversion rate for the preferred stock when converting to common stock.

If new stock is issued at a price per share lower than the conversion price then in effect for a particular series of preferred stock, the conversion price of such series will be reduced to a price determined by multiplying the conversion price by the following fraction:

[Common Outstanding pre-deal] + [Common issuable for amount raised at old conversion price]

[Common Outstanding pre-deal] + [Common issued in deal]

There are two primary variations of the weighted average formula depending on what constitutes “Common Outstanding” in the above formula. The first, and more common, is referred to as “broad-based weighted average” while the second is referred to as “narrow-based weighted average.”

Broad-based weighted average formula

The calculation of “Common Outstanding” in the broad-based formula includes all shares of common stock and preferred stock (on an as-converted to common basis) outstanding, common issuable upon exercise of outstanding options, common reserved for future issuance under the company’s stock option plan and any other outstanding convertible securities, such as warrants.

Below is an example of how broad-based anti-dilution protection works.

Assume that the pre-financing capitalization of the company is:

1,500,000  Common Stock

2,500,000  Series A Preferred Stock (issued at $1/share)

2,000,000  Series B Preferred Stock (issued at $2/share)

1,000,000  Options

7,000,000  Total

Also assume that there is a dilutive financing with the issuance of 2,000,000 shares of Series C Preferred Stock at $0.50 per share, for total gross proceeds of $1,000,000.

Series A adjustment

The Series A Conversion Price will be adjusted as follows:

Series A Conversion Price = $1.00 multiplied by

[Common outstanding prior to deal] + [Common issuable for amount raised at old conversion price]

[Common outstanding prior to deal] + [Common issued in deal]

= 7,000,000 + 1,000,000

   7,000,000 + 2,000,000

= $1.00 * (8/9) = $0.88

Thus, the number of shares of common issuable upon conversion of Series A is:

(2,500,000) x ($1.00 / 0.88) = 2,812,500

This results in a Series A Conversion Rate of 1.125:1

Series B adjustment

The Series B Conversion Price will be adjusted as follows:

Series B Conversion Price = $2.00 multiplied by

[Common outstanding pre-deal] + [Common issuable for amount raised at old conversion price]

[Common outstanding pre-deal] + [Common issued in deal]

= 7,000,000 + 500,000

   7,000,000 + 2,000,000

= $2.00 * (7.5 / 9) = $1.67

Thus, the number of shares of common issuable upon conversion of Series B is:

(2,000,000) x ($2.00 / $1.67) = 2,400,000

This results in a Series B Conversion Rate of 1.20:1

Narrow-based weighted average formula

The narrow-based formula only includes the common stock issuable upon conversion of the particular series of shares of preferred stock in ”Common Outstanding” in the formula. The narrow-based formula can be stated as follows:

Common Outstanding = Only the number of shares of the series of Preferred that is being adjusted.

Another version of the narrow-based formula would include the common stock issuable upon conversion of all shares of preferred stock outstanding in the Common Outstanding.

The effect of including the additional shares in the broad-based formula reduces the magnitude of the anti-dilution adjustment given to holders of preferred stock as compared to the narrow-based formula. The narrow-based formula provides a greater number of additional shares of common stock to be issued to the holders of preferred stock upon conversion than the broad-based formula. The extent of the difference depends upon the size and relative pricing of the dilutive financing as well as the number of shares of preferred stock and common stock outstanding.

Using the same example, the narrow-based formula works as follows:

(Common Outstanding = Common issuable upon conversion of particular series of preferred stock)

Series A adjustment

The Series A Conversion Price will be adjusted as follows:

Conversion Price of Series A = $1.00 multiplied by

[Common outstanding pre-deal] + [Common issuable for amount raised at old conversion price]

[Common outstanding pre-deal] + [Common issued in deal]

= 2,500,000 + 1,000,000

   2,500,000 + 2,000,000

= $1.00 * (3.5/4.5) = $0.77

Thus, the number of shares of common stock issuable upon conversation of Series A Preferred Stock =

(2,500,000) x ($1.00/$0.77) = 3,214,285

This results in a Series A Conversion Rate of 1.29:1

Series B adjustment

The Series B Conversion Price will be adjusted as follows:

Conversion Price of Series B Preferred Stock = $2.00 multiplied by

[Common outstanding pre-deal] + [Common issuable for amount raised at old conversion price]

[Common outstanding pre-deal] + [Common issued in deal]

= 2,000,000 + 500,000

   2,000,000 + 2,000,000

= $2.00 * (2.5 / 4.0) = $1.25

Thus, the number of shares of common stock issuable upon conversation of Series B Preferred Stock =

(2,000,000) x ($2.00/$1.25) = 3,200,000

This results in a Series B Conversion Rate of 1.6:1

Variations on weighted average formula

There are variations on both the traditional broad-based and narrow-based weighted average formulas. Among such variations is what might conveniently be called the “middle” formula. The difference depends on what constitutes “Common Outstanding.” The middle formula can be written as follows:

Common Outstanding = only common stock and preferred stock (on an as-converted to common basis) outstanding (in other words, don’t include common issuable upon conversion/exercise of debt, options and warrants).

Another company favorable variation of the weighted average formula that I have never seen in practice involves upward and downward conversion price adjustments if shares are issued at prices both greater and lesser than the applicable conversion price, although the conversion price will never be greater than the original purchase price of the preferred stock.

Once again, this proves that startup company lawyers need strong math skills.  If someone spots something wrong with the math, please let me know.

[Note:  this post and others on anti-dilution are based on (and complete sections of text copied from) an article titled "The Venture Capital Anti-Dilution Solution" written by Mike O'Donnell and Anton Commissaris.]

Comments

  • Mike

    Great article. Very useful.

  • Mike

    Can you elaborate on the mathematical goal of the anti-dilution adjustment? I originally thought this protection gave the preferred the same percentage ownership, as converted, before and after the dilutive event, but my math never seems to work out to confirm this after doing the conversion price adjustment. Is there some other calculation I could do to verify my new CP is correct, particularly in light of the weighted average name of the provision? That is, what am I averaging out?

    Thanks.

  • http://www.startupcompanylawyer.com Yokum

    The purpose of preferred stock anti-dilution adjustment is NOT to maintain a specific absolute ownership percentage. It is simply to give the investor the benefit (via a conversion adjustment) of issuances of stock at lower prices in the future.

  • Mike

    Yokum,

    I would appreciate your thoughts on something that has always bugged me about this.

    Given that any subsequent rounds of equity financing will demand to come in as senior to the existing preferred, and that the existing preferred will uniformly have veto rights over the creation of any senior class of preferred, why are all of these elaborate anti-dilution provisions necessary? Would the venture world be any different if all these anti-dilution provisions went away and the preferrreds simply retained their veto over the creation of any senior classes? Another way of asking this question: have you ever seen these provisions actually triggered?

    Thanks for your very informative site.

  • http://www.startupcompanylawyer.com Yokum

    @Mike – Anti-dilution clauses are actually relevant and triggered from time to time (as opposed to demand registration rights or redemption rights, which I have never seen used). I think that a protective provision by itself probably isn’t enough to protect a preferred investor. If the company does not get a subsequent down-round financing completed, the company may dissolve. If there are new investors in the down-round financing, the existing preferred investors have to choose between (i) rejecting the financing and dissolving the company, and (ii) accepting a dilutive financing. In most cases, the existing preferred investors have no choice but to accept the dilutive financing. If there are anti-dilution provisions, the existing preferred investors can accept the down-round financing and push the effect of the dilution to common shareholders.

  • Mary Grybko

    Is this something I would use to figure out the rate of return on net proceeds so that no dilution of earnings per share occurs? I'm working on a problem which asked me to compute the potential dilution of new stock issue, as well as computing the net proceeds.

  • http://www.startupcompanylawyer.com Yokum

    No. Different concept.

  • http://www.startupcompanylawyer.com Yokum

    No. Different concept.

  • Jing

    This is what I think the Broad-based weighted average formula come from:

    Company value with new money = Shares post financing at new price * new price= shares calculated as if new money were invested at old price * old price;

    Therefore:
    New price= old price * (outstanding shares + new money/old price) / shares post financing at new price

    Do you agree?

  • Mallika

    Thank you – much better than Tom Taulli's problematic examples here:
    http://www.businessweek.com/sm

  • rhoneyman

    i think you've described full ratchet anti-diution. in that case, the price for a round is adjusted to ensure that an investor's calculated value at the time of the down-round is kept equal to the amount that investor put into the company. it's an approach that makes little sense.

    with broad-based weighted average, the formula provides some compensation to earlier investors for having involved themselves in a project that for whatever reason failed to maintain value, let alone build value.

  • kp

    Quick question re: treatment of convertible notes.  Let's say a company is about to close its C round at $1 per share.  But it already raised $2M in convertible notes.  Where in the broad-based version of the formula above would the convert notes show?  Would it be included in Common Outstanding pre-deal and, if yes, at what conversion price?  I assumed that since it is a weighted-average calc, the convertible notes would show up only in Common Issued in Deal and Common Issuable in Deal at old Conversion Price. 
    Thanks