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You are here: Home / 2007 / Archives for August 2007

Archives for August 2007

What is a pay to play provision?

August 4, 2007 By Yokum Leave a Comment

A solution to incentivize investors to participate in a financing is called the “pay to play” provision.  Basically, investors that do not participate to their full pro-rata percentage of the financing are punished by losing certain rights.

Pay to play provisions tied to dilutive financings provide that only investors that participate in the dilutive financing are entitled to the benefit of the anti-dilution formula in effect.  Investors that do not participate do not receive any anti-dilution protection.  This technique is beneficial for both for the company and for the investor group because it encourages all investors to continue to fund the company during those times when such incentive is most needed, i.e., when the company is undertaking a difficult financing.

The incentive to participate in a dilutive financing can be strengthened by a variation on the pay to play concept.  Instead of merely losing anti-dilution protection with regard to the initial dilutive financing in which the investor does not participate, the investor loses anti-dilution protection with regard to such initial financing and all subsequent dilutive financings which may occur.  Mechanically, this can be accomplished by creating a “shadow” series of preferred stock identical in all respects to the original series but without any anti-dilution protection.  In the event that an investor fails to participate in a dilutive financing, all shares of preferred stock held by such investor are automatically converted into the shadow preferred.

Another harsher variant of the pay to play concept provides that upon an investor’s failure to participate in a dilutive (or potentially any) financing, such investor’s preferred stock is converted into common stock with the result that such investor will lose not only its anti-dilutive protection, but also its liquidation preference and other special rights of the preferred.  This approach may appear to be somewhat draconian, as it seems unfair where a particular investor may be unable to participate due to circumstances outside of its control.  This may be especially applicable to funds out of money, or strategic investors or angels that do not expect to participate in subsequent rounds.  Most investors do not want to give up the liquidation preference and preferred rights other than anti-dilution protection merely because they decided not to participate in a particular dilutive financing.

A disadvantage of the automatic conversion approach, whether into common stock or preferred stock, is that once an investor has been converted, the pay to play provision provides no further incentive for that investor to participate in the next dilutive financing.  If the goal for the company and the lead investors is to maximize the incentive for all investors to participate in all dilutive financings, the better approach would be to provide that if an investor fails to participate in the initial dilutive financing, such investor receives no anti-dilution protection with regard to such financing, but in the event that such investor elects to participate in a subsequent dilutive financing, such investor would be entitled to anti-dilution protection with regard to such subsequent financing.  Although this formula can be implemented with regard to multiple dilutive financings by creating several series of shadow preferred, each having a different conversion rate, this approach results in a very complicated capital structure for the company which can become overly cumbersome.

Another approach involves providing for a “springing warrant” which is then issued to each investor that participates in a dilutive financing.  This warrant is exercisable (at a nominal exercise price) for the additional number of shares of common stock equal to the number of additional shares which the applicable anti-dilution formula would allocate to such investor.  This approach results in a simpler capital structure for the company as it avoids the necessity of creating the shadow series of preferred.

The pay to play concept is based upon requiring participation by the investor in the dilutive financing.  The appropriate level of participation needs to be carefully considered.  Pay to play clauses are often written to require each investor to participate in the dilutive financing to the extent of its percentage ownership of the company.  Although this is typically the amount of the financing which the investors are entitled to purchase by reason of their contractual rights of first refusal, this approach may not work properly because the sum of the ownership percentages of the various investors will be less than 100%, and the primary purpose of the pay to play clause is to assist the company in raising the total amount of financing which it requires.  Requiring each investor to purchase a percentage of the dilutive financing equal to its pro rata ownership among the investor group won’t quite work either because the sum of these percentages will always be 100%, leaving no room for a potential new investor.

Conceptually, the optimal approach is to require each investor to purchase a percentage equal to its pro rata ownership among the investor group of that portion of the financing allocated to the existing investors by the board of directors of the company, with the balance of the financing (if any) being purchased by the new investors.  Under this formula, if all of the preceding investors participate, together with any new investors, the company will receive 100% of the funds it is seeking to raise.  If the required percentage is higher than the percentage which such investor has a contractual right to purchase, the company must offer the investor the opportunity to purchase this greater amount in order to implement the pay to play clause.

[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.]

Filed Under: Series A

What is full ratchet anti-dilution protection?

August 4, 2007 By Yokum 3 Comments

Full ratchet anti-dilution protection is conceptually much simpler than the weighted average approach, and its effect on the company is considerably more severe in the event of a dilutive financing.  Under the full ratchet formula, the conversion price of the preferred stock outstanding prior to such financing is reduced to a price equal to the price per share paid in the dilutive financing.

For example, if the outstanding preferred stock was previously sold at a price of $1.00 per share, and the new preferred stock in the dilutive financing is sold at a price of $0.50 per share, the effective price of the previously outstanding preferred stock would be reduced to $0.50 per share with the result that each share of such preferred stock previously convertible into one share of common stock would now be convertible into two shares of common stock.

Under the full ratchet formula, this same result is obtained whether the company raises $100,000 at a price of $0.50 per share or raises $10,000,000 at a price of $0.50 per share. In contrast, the amount of money raised in the dilutive financing is an important factor in determining the new conversion price in the weighted average formula.

Below is an example of how full-ratchet anti-dilution protection works.

Assume that the pre-financing capitalization of the company is (same as example for weighted average anti-dilution protection):

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 Conversion Price of Series A Preferred Stock becomes $0.50.

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

(2,500,000) * ($1.00/$0.50) = 5,000,000

This results in a Series A Conversion Rate of 2:1

Series B adjustment

The Conversion Price of the Series B becomes $0.50.

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

(2,000,000) * ($2.00/$0.50) = 8,000,000

This results in a Series B Conversion Rate of 4:1

Problems with the full ratchet

At first glance, the full ratchet formula seems very attractive for investors as it completely protects their investment from any subsequent price erosion until the occurrence of a liquidity event (at which time the preferred stock would normally be converted to common stock). The company should argue that it is unfair to have the company bear all the downside price risk where there is no limit on the upside potential for the investors.

However, a full ratchet formula can also be problematic for the investors in a syndicate.  Because the prior money invested is fully protected with regard to price decreases, if the company’s prospects deteriorate and the company is forced to undertake a dilutive financing, there is no incentive for all of the investors to participate in the new dilutive round.  Therefore, the lead investor(s) may have difficultly inducing the smaller investors in the syndicate to continue to participate, and the burden of continuing to fund the company can fall heavily on the lead investor(s).  In addition, the application of the full ratchet will be disclosed to the incoming invstors in the new round upon review of the company’s charter documents in the due diligence process.  This will make the company appear significantly less attractive to invest in and will exacerbate the problems of an otherwise already difficult financing.  Because the number of pre-financing shares outstanding increases due to the anti-dilution adjustment, the price per share of the new series of preferred stock will decrease.  This results in a circular formula, that requires strong spreadsheet skills to solve.

In addition, as a result of the anti-dilution protection for the preferred stock, the percentage ownership of the common stock will decrease, which decreases the incentive of management and employees.

[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.]

Filed Under: Series A

What is weighted average anti-dilution protection?

August 4, 2007 By Yokum 12 Comments

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.]

Filed Under: Series A

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