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.]