Term Sheet 101: Price-Based Anti-Dilution

Price-based anti-dilution provisions are perhaps the most esoteric and difficult provisions in a venture capital or sophisticated angel preferred stock financing (certainly from a drafting perspective in the corporation’s Certificate of Incorporation).  In a nutshell: the Preferred Stock is convertible into common stock.  The underlying common stock of the Preferred Stock is where all of the “up side” for the investors is (see discussion on liquidation preferences).  The Preferred Stock will always start out convertible one-for-one (1:1) into shares of common stock.  What price-based anti-dilution protection affords the investors is a mechanism for adjusting the conversion rate of the Preferred Stock if the corporation sells shares of capital stock at a price below the price per share paid by the preferred investors.  If that happens, the conversion rate of the Preferred Stock will adjust and provide the investors with more underlying conversion shares.

The big question is, how much will the conversion rate adjust?  Both “broad based” and “narrow based” methods use a weighted average, mathematical formula approach for determining the new conversion rate of the Preferred Stock.  The conversion rate = purchase price per share / conversion price.  The conversion price starts as the purchase price per share.  Anti-dilution provisions lower the conversion price, and so by lowering the denominator in this formula, the conversion rate of the Preferred Stock into common stock is increased.

The weighted average approach takes into account both the new price per share at which shares of capital stock are sold (the lower, the more dilutive) and the number of dilutive shares sold (the higher, the more dilutive). The formula is as follows:

This is complicated!—but here is the key to understanding the anti-dilution formula: how the term CS, or number of shares of common stock outstanding, is defined.  In a “broad based” weighted average formula, CS is defined as broadly as possible to include common stock outstanding, the common stock issuable upon conversion of outstanding Preferred Stock and the common stock issuable upon exercise of all outstanding options and warrants.  Broad based adjustments are the most favorable to the holders of common stock because it makes the least adjustment.  CS is in both the numerator and the denominator, so the larger that number the less impact the dilutive issuance will have on the New CP.

“Narrow based” adjustments (used far less often than broad based adjustments in deals) uses the same formula but defines CS more narrowly.  CS may include just the common stock outstanding (and not the common underlying Preferred Stock and outstanding options and warrants)—this is very “narrow”, or CS may include the common stock outstanding and the common stock underlying the Preferred Stock (but not the common stock underlying options and warrants)—still narrow, but not as narrow.

The “Full Ratchet” can be draconian.  It does not use a formula and simply adjusts the old conversion price to equal the new purchase price per share in the dilutive issuance—essentially re-pricing the entirety of the Preferred Stock financing.  The “full ratchet” can be fair in certain circumstances but what can be draconian is a complete repricing of the Preferred Stock financing if there is a very small (in theory, as little as 1 share) dilutive issuance that economically has minimal impact.

About Bo Sartain

Combining his background as a systems engineer (Electronic Data Systems) and venture capital attorney (Wilson Sonsini, Haynes and Boone), Bo has automated the process of preparing the formative and early-stage financing legal documents as the Founder and CEO of VENTURE DOCS. (www.venturedocs.com), an on-line SaaS company offering customized incorporation and founder documents, stock option plans and transaction documents for common stock, convertible note and preferred stock financings. Bo earned his JD, Order of the Coif, and MBA from the University of Texas and his BA from Duke University.