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

In a Series A financing, the priority of the liquidation preference vis a vis other series of preferred is not relevant because there are no other series of preferred stock. However, in a Series B financing, the new investors may request that their liquidation preference be senior to the Series A.  In other words, the Series B gets paid before the Series A. The Series A investors may argue that the priority of the Series B liquidation preference should be the same, or “pari passu,” with the Series A.  Founders and companies should be very careful when negotiating liquidation preferences (and any term) at the Series A stage.  When the Series B financing occurs, the Series B will demand at least the same level and priority of rights as the Series A.  Although a 2x preference may not seem that onerous while raising $2 million of Series A, a 2x preference on $20 million will significantly affect the holders of common stock.

A cap on participation limits the amount received by the preferred stock to a fixed amount. The cap is typically fixed as a multiple of the original investment, such as 2x or 3x. Once holders of preferred stock have received the cap amount, they will stop participating in distributions with the common stock. Thereafter, holders of common stock receive all proceeds until holders of common stock have received the same amount per share as the preferred. After that transaction value, holders of preferred stock will be economically incentivized to convert to common stock in order to receive maximum value. Unfortunately, this math is not particularly easy to understand.

Imposing a cap on participation allows the holders of preferred stock to receive a return on their investment without having to convert their holdings to common stock, but leaves the incentive to convert in place where the sale or liquidation occurs at a high valuation.

There are two basic types of liquidation preferences: “non-participating” and “participating.”

“Non-participating” preferred typically receives an amount equal to the initial investment plus accrued and unpaid dividends upon a liquidation event.  Holders of common stock then receive the remaining assets.  If holders of common stock would receive more per share than holders of preferred stock upon a sale or liquidation (typically where the company is being sold at a high valuation), then holders of preferred stock should convert their shares into common stock and give up their preference in exchange for the right to share pro rata in the total liquidation proceeds. Non-participating preferred stock is favored by holders of common stock (i.e. founders, management and employees) because the liquidation preference will become meaningless after a certain transaction value.

Please note that each series of preferred stock may be economically incentivized to convert to common stock at different transaction values due to different preference amounts per share for the different series.  This necessitates creating complex spreadsheets to model what happens upon a sale of company at different transaction values.  The most sophisticated spreadsheets will also take into account whether options and warrants are in the money at certain transaction values, which will affect whether or not they are exercised, which will then affect the price per share.  These circular formulas are best left to CFOs with strong math skills or attorneys that deal with these spreadsheets all the time.

“Participating” preferred also typically receives an amount equal to the initial investment plus accrued and unpaid dividends upon a liquidation event. However, participating preferred then participates on an “as converted to common stock” basis with the common stock in the distribution of the remaining assets.

Participating preferred stock is favored by investors because they will receive a preferential return over both low and high exit transaction values.  An argument in favor of participating preferred stock is that if a company is sold shortly after the investment, the founders may receive a significant return on their investment (since they have typically paid a much lower price than holders of preferred stock) while the holders of preferred stock may receive little or no return on their investment, particularly where the liquidation preference is 1x.  A counter-argument is that if a company is sold for a high price, the holders of preferred stock have no incentive to convert their shares into common stock and, as a result, are able to “double-dip” into the proceeds by receiving both the preference amount and the participation proceeds.  Thus, one compromise is a participating preferred with a cap, which will be covered in the next post.

The amount of the liquidation preference is a function of the risk of the investment.  In typical venture financings, the amount of the liquidation preference is the amount invested by the investors.  In other words, if the Series A was issued for $1.00/share, a holder of one share of Series A receives $1.00 prior to any distributions to holders of common stock.  This is referred to as a 1x preference.  During the 2001 to 2003 time period, liquidation preferences of multiples greater than the purchase price (expressed as 2x, 3x, etc.) were not unusual.  Liquidation preferences of greater than 1x may be negotiated when a company has had difficultly raising funds.

Aggressive liquidation preferences can wipe out the interests of holders of common stock absent a “home run.”  If a company raises a lot of money with liquidation preferences greater than 1x, then the amount that the company must be sold for in order for the holders of common stock to receive a return may be quite high.  This is sometimes not fully understood by founders and management.

The most important economic provision in a venture financing other than valuation is probably the liquidation preference.  One of the basic features of preferred stock is providing for an ordering of returns to different classes and series of stockholders upon significant company events. The liquidation preference provision is the principal mechanism to allow preferred stock to receive a priority return upon these events.

The triggering events for a liquidation preference payment typically include both a winding up of the company (e.g. a true liquidation) and a sale of the company through a merger, stock sale, sale of assets or other acquisition of the company (also known as a “deemed liquidation”).  The liquidation preference is meaningless if the company goes public, as the preferred stock issued to investors converts to common stock and the liquidation preference goes away.

The structuring of liquidation preferences is critical and is not always fully appreciated by companies and founders as they set a precedent for future financing rounds, which have significant economic effects.  The elements of the preferences can be varied to create different incentives and returns. The key variables are: (1) the amount of the initial preference to be paid to preferred stockholders, (2) the priority of payments among different classes (preferred versus common) and series (series A versus series B) of stock and (3) the extent, if any, of participation of the preferred stock with the common stockholders in the distribution of the remaining assets.

The liquidation preference is one of the features of preferred stock that companies can point to as a means of justifying the grant of stock options with a “fair market value” exercise price that is lower than the purchase price for the preferred shares in the latest round of financing. The liquidation preference justifies a high price for the preferred stock, such as $1.00/share, while maintaining a low common stock fair market value, such as $0.10/share.  This is good for the company as employees view the discount as immediate “paper” profit.