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.]

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.]

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.]

Almost all venture financings have some form of anti-dilution protection for investors. In the context of a venture financing, anti-dilution protection refers to protection from dilution when shares of stock of stock are sold at a price per share less than the price paid by earlier investors. This is known as price-based anti-dilution protection. Anti-dilution protection, along with the liquidation preference, are two of the fundamental features distinguishing preferred stock typically sold to investors from common stock generally held by founders and employees.

Preferred stock is normally convertible at the option of the holder at any time into common stock, usually on a share for share basis, and is typically automatically converted upon the occurrence of a qualified initial public offering. Price-based anti-dilution adjustments involve increasing the number of shares of common stock into which each share of preferred stock is convertible. In addition, an anti-dilution adjustment will affect the voting rights of the company’s stockholders because the preferred stockholder is almost always entitled to vote on an as-converted to common-stock basis. The primary difference between the various anti-dilution formulas to be described in upcoming posts is the magnitude of the adjustment under different circumstances.

Although an investor may be diluted in the sense that it may own a smaller percentage of the company following any new stock issuance, the value of the portion of the company owned by such investor has theoretically increased due to the increase in the total company valuation due to the higher price per share paid by the new investor. Occasionally, absolute anti-dilution protection is requested by investors (or executives) against any dilution arising as a result of the subsequent sale of stock, which basically guarantees a certain percentage ownership of the company for a specified time period or until the occurrence of a certain event, such as a initial public offering. However, these provisions may impair the company’s ability to raise financing.

The other type of anti-dilution protection that preferred stock investors always obtain is structural anti-dilution protection. This is an adjustment of the conversion price of their preferred stock into common stock upon the occurrence of any subdivisions or combinations of common stock, stock dividends and other distributions, reorganizations, reclassifications or similar events affecting the common stock. For example, in a stock split, an investor will expect a provision to the effect that, to the extent the common stock is subdivided by a stock split into a greater number of shares of common stock, the conversion price of each series of preferred stock then in effect shall, concurrently with the effectiveness of such subdivision, be proportionally decreased. This type of anti-dilution protection ensures that the investor holding preferred stock is treated as if such investor held common stock without the need to actually convert into common stock and lose the features associated with the preferred stock held by such investor.

[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.]

Preferred stock should automatically convert upon a majority (or super-majority) vote of the preferred stock or upon an IPO.

Preferred stock will typically convert to common stock with the consent of a majority of the preferred stock. In some financings, the threshold will be raised to 2/3 or higher in order ensure that there is sufficient consensus for conversion. When preferred stock converts into common stock, all of the rights of the preferred stock contained in the certificate of incorporation (such as liquidation preference, protective voting rights, anti-dilution protection) disappear.

Investors in different series of preferred stock may have different economic interests in converting in connection with a merger. For example, with a non-participating preferred stock, the Series A may determine that it is economically beneficial to convert even at a low transaction value because they will receive more merger proceeds as a common stockholder rather than keeping the liquidation preference of the Series A. At the same time, the Series B may determine that it is economically beneficial not to convert until a higher transaction value because the liquidation preference is greater than the merger proceeds to the common stockholders. In that case, having all of the preferred stock convert (and lose their liquidation preference) upon a majority vote of all preferred would result in a less than optimal economic outcome for the Series B. Therefore, some investors will insist that the trigger for conversion is by a series vote, instead of a vote of all preferred.

Typically, there are a couple of thresholds that need to be met for the preferred stock to convert in an IPO: amount raised and price per share. The amount raised is generally set high enough (such as $25 million or more) in order to ensure that the IPO is a legitimate IPO. The investors want to protect themselves against the preferred stock converting in an IPO on a minor stock market raising very little money because there will likely not be a liquid market for the stock. Thus, the defined term in the documents is typically “Qualified IPO.”

The price per share trigger is typically set at three to five times the per share investment price. In a Series A financing, the per share trigger is typically 5x. In a later stage financing, the trigger is typically 3x or lower. This is because the valuation of an early stage company in as Series A financing may be under $10 million, and 5x would only be $50 million, which would still be well short of the $250 million or $300 million market capitalization that a company would need for a legitimate Nasdaq IPO. In a later stage financing with a $100 million valuation, the per share trigger could be set a 2x or 3x, in order to ensure that the valuation in the IPO is $200 million or $300 million. If the amount raised or per share threshold is not met, then a company would need to rely upon a majority or super-majority vote of the preferred (or by series) to convert.

Many of the provisions in a typical venture financing are designed with an IPO or an M&A event in mind. For example, piggyback and S-3 registration rights (to be described in a later post) are designed to ensure liquidity for an investor after an IPO. A liquidation preference is designed to dictate the order of payment of proceeds in a merger. It would be difficult for an investment bank to market an IPO of common stock of a company where there still was preferred stock outstanding. Therefore, venture capital preferred stock is designed to convert upon an IPO. In certain states, such as California, amending the articles of incorporation or sale of the company require a majority vote of each class of stock, which means common as a class and preferred as a class. In some cases, the preferred stock may want to convert into common stock in order to outvote the common stock. While there are plenty of examples of preferred stock that have debt-like characteristics and are not convertible to common stock, they are not used in venture financings.

A redemption right is the right of the investors to force a company to repurchase their shares. According to the WSGR survey of private company financing trends from 2005 through Q1 2007, redemption rights were included in about one third of venture financings. As a practical matter, redemption rights, like demand registration rights, are almost never exercised. If the company is doing so poorly that the investors want their money back, there probably isn’t any money left to redeem the shares. However, the threat of redemption is probably helpful to provide investors with leverage against “walking dead” portfolio companies that generate enough revenue to stay alive in a niche market, but haven’t grown enough to be interesting M&A or IPO candidate.

Due to restrictions under Delaware (and other state corporate law), a company might not be legally permitted to redeem shares. In this case, investors may request that certain penalty provisions take effect where redemption has been requested but the company’s does not have enough funds to permit redemption or redemption would leave the company legally insolvent. These penalty provisions may include the redemption amount being paid via a promissory note and/or the investors being allowed to elect a majority of the board of directors until the redemption price is paid in full.

The principal variables in the redemption right are when the right is triggered and the redemption price. Most redemption rights are set so they cannot be triggered until at least 5 years after the Series A financing. This is because a company needs a sufficient amount of time to achieve results, while a venture fund needs to be able to liquidate an investment at the end of life a fund. The redemption price is typically the original purchase price plus accrued but unpaid dividends. In “East Coast” investor-friendly deals, the investors may try to add cumulative dividends to the redemption price, which essentially gives the investor a guaranteed 8%+ rate of return, assuming of course, that there is cash available for redemption. The redemption may be triggered by a majority or super-majority vote of investors. Some investors may be allowed to opt out of the redemption or the redemption provision may require all shares to be redeemed. The redemption may occur in multiple installments over one to three years.

Wilson Sonsini Goodrich & Rosati publishes a report on private company financing trends. According to VentureOne, WSGR represents more companies that receive venture financing than any other law firm in the United States. In 2007, WSGR represented companies in over 500 venture equity and debt financings, which was 20.6% market share among U.S. law firms.

Various issues of the report cover valuation trends, amounts raised by series, up rounds vs. down rounds, liquidation preferences, pay-to-play, dividends, anti-dilution and redemption rights.  Authors of articles include WSGR attorneys, venture capitalists, accountants and D&O specialists.

WSGR Entrepreneurs Report Fall 2008 – Printable PDF or HTML version

WSGR Entrepreneurs Report Summer 2008 – Printable PDF or HTML version

WSGR Entrepreneurs Report Spring 2008 – Printable PDF

WSGR Entrepreneurs Report Winter 2007 – Printable PDF

WSGR Entrepreneurs Report Fall 2007 – Printable PDF

WSGR Entrepreneurs Report Summer 2007 – Printable PDF