FUNDING HAZARDS : CONTRACT TERMS : ANTI-DILUTION IN…
CHAPTER INDEX
ANTI-DILUTION: THE HIDDEN OWNERSHIP COST
INVESTMENT HAZARDS
An investment round can change your ownership twice: when new shares are issued and when earlier investors receive an anti-dilution adjustment.
Understand the formula before agreeing to the valuation.
WHAT THE CLAUSE PROTECTS
DOWN-ROUND PROTECTION
Price-based anti-dilution protects investors when qualifying shares are issued below their existing conversion price.
The adjustment improves their conversion entitlement. Their ownership percentage can still fall after the financing.
THE TRIGGER IS PRICE PER SHARE
A LOWER HEADLINE VALUATION IS ONLY PART OF THE PICTURE
A down round means new shares are sold at a lower price per share than a previous financing.
Read the clause to identify which issuances trigger protection and which are excluded.
THREE METHODS, THREE OUTCOMES
CHAPTER 1
FULL RATCHET
THE STRONGEST ADJUSTMENT
The investor's conversion price resets to the new lower issue price.
The amount raised does not affect the adjustment. A small qualifying issuance can reprice the entire protected holding.
FULL RATCHET IN NUMBERS
A $1 SHARE PRICE FALLS TO $0.50
An investor pays $1 million for 1 million preferred shares, initially converting 1:1.
A qualifying issuance at $0.50 resets the conversion price to $0.50. Those preferred shares now convert into 2 million ordinary shares without another investment.
BROAD-BASED WEIGHTED AVERAGE
PRICE AND ROUND SIZE BOTH MATTER
The adjustment considers the price decline and the number of new shares issued relative to the existing share base.
A smaller down round creates a smaller adjustment than a larger round at the same price.
WHAT DOES BROAD-BASED COUNT?
THE CONTRACT DEFINES THE SHARE BASE
The base generally includes ordinary shares, preferred shares on conversion, and specified options, warrants or other convertible securities.
Check treatment of the unallocated option pool. The label alone does not settle every inclusion.
NARROW-BASED WEIGHTED AVERAGE
A SMALLER BASE PRODUCES A LARGER ADJUSTMENT
The same general method uses fewer existing shares in its calculation.
Some definitions count only outstanding preferred shares. Other drafting uses a different restricted base. Read the definition rather than relying on the name.
HOW THE METHODS COMPARE
ADDITIONAL FOUNDER DILUTION UNDER COMPARABLE ASSUMPTIONS
Full ratchet: largest adjustment.
Narrow-based weighted average: generally larger than broad-based.
Broad-based weighted average: generally the smallest of these three.
Actual outcomes depend on the formula and share-base definitions.
RUN THE NUMBERS
CHAPTER 2
ONE ILLUSTRATIVE CAP TABLE
SIMPLIFIED ASSUMPTIONS, NOT AN ACTUAL FINANCING
Before the new round:
Founder: 9 million ordinary shares.
Investor A: 1 million preferred shares, bought at $1 each and initially converting 1:1.
New round: Investor B pays $1 million at $0.50 per share, receiving 2 million shares.
Ignore option pools and other securities.
THE WEIGHTED-AVERAGE FORMULA
CP2 = CP1 × (A + B) / (A + C)
CP1: conversion price before the issuance.
CP2: adjusted conversion price.
A: existing shares counted under the contract.
B: new proceeds divided by CP1.
C: new shares issued.
Conversion ratio = original issue price / adjusted conversion price.
BROAD-BASED RESULT
$0.9167 ADJUSTED CONVERSION PRICE
A = 10 million existing shares.
B = $1 million / $1 = 1 million.
C = 2 million new shares.
CP2 = $1 × 11 / 12 = $0.9167.
Investor A converts into approximately 1.091 million ordinary shares.
NARROW-BASED RESULT
ILLUSTRATION USING ONLY INVESTOR A'S PREFERRED SHARES
Assume the contract counts only 1 million existing preferred shares in A.
B = 1 million. C = 2 million.
CP2 = $1 × 2 / 3 = $0.6667.
Investor A converts into 1.5 million ordinary shares.
A different narrow-base definition gives a different result.
FOUNDER OWNERSHIP AFTER THE ROUND
SAME FUNDING, DIFFERENT ANTI-DILUTION TERMS
No price adjustment: 75.00%.
Broad-based weighted average: 74.44%.
Illustrative narrow-based weighted average: 72.00%.
Full ratchet: 69.23%.
Calculated on an as-converted basis using the preceding assumptions and a fixed 2 million new shares.
PROTECTION STILL PERMITS DILUTION
INVESTOR A'S ORIGINAL OWNERSHIP WAS 10%
After the round, Investor A owns:
No adjustment: 8.33%.
Broad-based: 9.02%.
Illustrative narrow-based: 12.00%.
Full ratchet: 15.38%.
An adjustment can reduce dilution or even increase ownership. It does not guarantee a fixed percentage.
READ THE WHOLE CONTRACT
CHAPTER 3
PAY-TO-PLAY
PROTECTION CAN DEPEND ON INVESTING AGAIN
A pay-to-play provision can require investors to participate in a later round to retain anti-dilution rights.
Failure to participate may remove protection or change the share class. The consequences must be defined in the documents.
WAIVERS CAN PRESERVE INCENTIVES
AN ADJUSTMENT CAN BE NEGOTIATED
Existing investors may agree to waive, reduce or modify an adjustment for a particular financing.
Model the ownership consequences before negotiating. A large founder dilution can weaken the incentive to keep building.
IMPLEMENTATION CHANGES THE ECONOMICS
CONVERSION ADJUSTMENT OR ADDITIONAL SHARES
US-style preferred financing commonly changes the conversion ratio. Other structures may issue additional shares.
If additional preferred shares are issued, check whether liquidation preferences, redemption rights or dividends also increase unintentionally.
FOUNDER NEGOTIATION PRIORITIES
A PRACTICAL STARTING POSITION
Consider broad-based weighted-average protection as a starting point.
Define the share base and excluded issuances precisely. Examine pay-to-play and waiver mechanics.
Model the cap table under several lower prices and funding amounts, then check effects on voting and board rights.
BEFORE ACCEPTING THE TERM SHEET
INVESTMENT HAZARDS: REVIEW THE OWNERSHIP COST
Ask for the exact formula and an as-converted cap table showing its effect.
Check the term sheet against the definitive documents and company constitution. Implementation depends on jurisdiction and drafting.
This is an educational explanation. Have the actual clause reviewed for your company.