Financing Term Sheet Deep Dive: Anti-Dilution

Whether you’ve only recently decided to seek out capital for your business or you’ve already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process.  

In this series we’ll look to shed some light on the legal language contained in that term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both Company and Investor.  Check out an overview here.

Financing Term Sheet Deep Dive will be published each Monday morning until conclusion. For more information, check out www.hoeglaw.com or drop Rick a line at rhoeg@hoeglaw.com.

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Last week, in discussing the right of Investors to convert their preferred stock into common, we touched on the concept of “anti-dilution” provisions intended to alter the number of shares that the preferred stock might convert into.

Today, we take a deeper look at this complicated concept.

The overall idea of “anti-dilution” protection is based on a simple conceit: if the Company decides to sell stock at a price below what the Investors paid, the Company will be issuing more “value” than it receives in cash (on a relative basis), and the current Investors’ interests will be “diluted”.  The Investors, naturally, would like to negotiate for some protection in the case of an issuance of that nature, and since the Investors’ rights are, in some ways, dependent on the number of shares into which their stock can convert,  the primary mechanism developed for affording the Investors this protection is a formula-based increase in their “conversion” shares

There are two primary approaches to giving such protection found in a financing term sheet.

“Typical” Broad-Based Weighted Average

The NVCA model term sheet includes a typical (“weighted average”) anti-dilution provision:

In the event that the Company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be adjusted in accordance with the following formula:

CP= CP1 * (A+B) / (A+C)

CP= Series A Conversion Price in effect immediately after new issue

CP= Series A Conversion Price in effect immediately prior to new issue

A = Number of shares of Common Stock deemed to be outstanding immediately prior to new issue (includes all shares of outstanding common stock, all shares of outstanding preferred stock on an as-converted basis, and all outstanding options on an as-exercised basis; and does not include any convertible securities converting into this round of financing)

B = Aggregate consideration received by the Corporation with respect to the new issue divided by CP1

C = Number of shares of stock issued in the subject transaction

Easy, right?  I’m sure we can just move on.

All kidding aside, though described in complicated terms (and terms that are generally mirrored in many of the deals I see), the overall concepts are relatively simple.

If you recall from our discussion of conversion last week, the initial conversion right is usually set on a 1:1 basis (i.e., 1 share of preferred stock becomes 1 share of common).  In the definitive documents, this is established by dividing the preferred’s initial purchase price by a “conversion price” initially equal to that purchase price; the result being termed a “conversion ratio” (or similar).  The conversion ratio can then be multiplied by the number of shares of preferred an Investor holds to determine the number of shares of common to which they are entitled.  Obviously with the numbers starting the same, the initial math leads to 1 share for 1 share.

The anti-dilution provision comes in to change that math.  Let’s break it down.

 CP= Series A Conversion Price in effect immediately after new issue

This is the number we are trying to calculate.  The number that will set a new conversion ratio for the Investors’ shares.

CP= Series A Conversion Price in effect immediately prior to new issue

This is the conversion price that is current as of the date of the dilutive issue.  If this is the first dilutive issue, the conversion price will be the same as the purchase price of the Investor’s shares (assuming that the Investor’s shares were initially sold with a 1:1 conversion right).  If it is not the first dilution event, the conversion price will be whatever reduced number was established in the prior round.

A = Number of shares of Common Stock deemed to be outstanding immediately prior to new issue (includes all shares of outstanding common stock, all shares of outstanding preferred stock on an as-converted basis, and all outstanding options on an as-exercised basis; and does not include any convertible securities converting into this round of financing)

This is the current “fully diluted” capitalization of the Company (depending on how it is written).  It is the term designed to establish how many shares are outstanding prior to the dilutive round.

Note that as drafted in the model term sheet, the concept of shares reserved for issuance is not included in the calculation of “A”.  This is a bit unusual (and noted in footnote to the model terms).  Ordinarily, an Investor or other interested party would include shares reserved in a pool to establish a “fully diluted” number, but by not including it here, the calculation is actually a bit more “narrow” than a full “broad-based” weighted average might otherwise be.  In this case, a “narrowing” of the base benefits the existing Investors as it will give them the right to more shares of common stock than a “broader” base would have.

(Which is all a long way of saying: there are many permutations of the formula and both Company and counsel should review carefully both in the term sheet and in the definitive documents to ensure a clear understanding of the term’s implications.)

B = Aggregate consideration received by the Corporation with respect to the new issue divided by CP1

This is a weird and complicated way to say: “the number of shares that the new folks would have purchased were this new round not dilutive”.

In other words, let’s say the new investors are putting in $5M and it buys them 10 million shares.  If the current conversion price for existing Investors is $1, then the new investors should have only received 5 million shares if they weren’t diluting the existing Investors.  That 5 million share number would be “B”.

(A+B)

We can now give some form to “(A+B)”.  It is the number of shares that would be outstanding in the Company’s fully (or partially) diluted capitalization were the new Investors to have purchased non-dilutive shares.

Piggybacking on the foregoing example, if we assume that the Company has 10 million shares outstanding prior to the dilutive round, “A+B” would be 15 million.

C = Number of shares of stock issued in the subject transaction

Here is where reality sets in.  This is the number of shares the new, dilutive investors are actually going to receive.  In the foregoing example, this would be 10 million.

(A+C)

So this is the “true” fully diluted capitalization of the Company after the new, dilutive investors come in.

Going off the above example, “A+C” is 20 million (10 million shares for the present capitalization plus 10 million actually sold).

(A+B) / (A+C)

Based on the foregoing, then, this is the ratio of “what should have been issued” to “what was actually issued”.  Using our hypothetical it is 0.75 (being 15M/20M).  This is the true modifier of the existing Investors’ conversion right as we see in the full formula.

(You can also see here how a “broadening” of the base in “A” to include more shares such as option pools reduces the anti-dilution modifying effect.  Imagine for example that a pool of 10M more shares had been included in the “A” calculation.  The resulting ratio would be 25M/30M or 0.83.  In other words, the number of shares in the Company’s existing capitalization matters. It establishes the “average” in “weighted average”.)

CP= CP1 * (A+B) / (A+C)

In our example then, the $1 per share CP1 is modified by 0.75 to arrive at a new CPconversion price of $0.75.  In the definitive documents, that new $0.75 conversion price would divide into the Investor’s $1 purchase price to establish that, after the dilutive issuance in question, each share of Investor preferred would convert into 1.333 shares of common stock ($1.00/$0.75).

Though complicated, this is the most common form of anti-dilution protection as it both affords the Investors some comfort as well as allows the Company to make small dilutive issuances, if necessary, without “giving away” large chunks of equity to the existing Investors.

 Full Ratchet

Seen much less frequently than “weighted average” anti-dilution terms (whether formulated on a “narrow” or “broad” basis), full ratchet anti-dilution protection is much, much easier to understand, but also much more potentially destructive to a Company’s capitalization structure.

The NVCA model term sheet describes full ratchet anti-dilution protection as follows:

In the event that the Company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be adjusted in accordance with the following formula:

the conversion price will be reduced to the price at which the new shares are issued.

As I said, easy to understand.  If the Company issues any shares for less than the current conversion price, that conversion price is reduced to the level of the dilutive offering.  No math involved.

In our above example, the new investors purchased shares at $0.50 per share (since $5M bought then 10M shares).  With the existing Investors’ conversion price reduced to such same $0.50 level, they would then be entitled to receive 2 shares of common stock for every 1 share of Series A preferred ($1.00/$0.50), or about 50% more than they would have received under a “weighted average” calculation.

But that’s within the realm of reason.  The real issue with “full ratchet” lies in the fact that a single share sold at the reduced price triggers the full effect.  So imagine that the Company had only sold two shares of $0.50 dilutive stock for $1 total.  Under full ratchet, the Investors’ common holdings would be doubled for that $1.  If the Company had instead negotiated a “weighted average” calculation like the one shown above, the effect would be far less draconian.  (Each share of Series A would be entitled to convert into 1.0001 shares of common stock (Conversion Price = $1.00*(10,000,001/10,000,0002)).)

“Full ratchet” all but requires a Company strapped for cash to seek a waiver of the Investors’ rights.  This puts far more power in the hands of the Investors, and as a result is generally avoided by companies seeking financing.

(On the question of waivers, it is worth noting that the governing documents of a Company will almost always include the ability of the Investors to waive the application of any anti-dilution protections.  This waiver right is generally exercisable by whatever portion of the Investor class is entitled to approve Investor matters (as contemplated in the protective provisions and in respect of other pertinent thresholds).  The existence of this waiver right allows the Company to function in respect of receiving dilutive funds, but that is not the end of the matter.  Existent terms still determine the leverage of the parties when a change in circumstance is requested, and a Company facing off against a group of Investors with “full ratchet” protection is likely to find itself in a far more difficult position than had  “weighted average” been originally negotiated.)

Exempt Offerings

Because “dilutive” stock issuances can have such a significant impact on a Company’s capitalization, the financing term sheet generally identifies and defines certain classes of issuance that will not be deemed “dilutive” for this purpose.

The NVCA model term sheet reads as follows on this point:

The following issuances shall not trigger anti-dilution adjustment:

(i) securities issuable upon conversion of any of the Series A Preferred, or as a dividend or distribution on the Series A Preferred

(ii) securities issued upon the conversion of any debenture, warrant, option, or other convertible security

(iii) Common Stock issuable upon a stock split, stock dividend, or any subdivision of shares of Common Stock

(iv) shares of Common Stock (or options to purchase such shares of Common Stock) issued or issuable to employees or directors of, or consultants to, the Company pursuant to any plan approved by the Company’s Board of Directors [including at least [_______] Series A Director(s).

The model terms also point out that other classes of stock issuance (such as those associated with strategic rather than financial arrangements including equipment leases) might also be exempted from treatment as “dilutive” as a result of term sheet negotiations.

For the most part though, the categories are built almost entirely to avoid the concept of “double counting”.  If a share of preferred stock or warrant is dilutive when issued, fine, the protections are triggered, but there will not be a second dilution event subject to protection if and when it converts or is exercised.  Other negotiated categories tend to follow the same pattern, even if they are not expressly called out in the NVCA’s terms.

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Throughout this series, I will be basing my discussion in part on the order and prominence of certain terms set forth in the National Venture Capital Association (“NVCA”) Model Term Sheet.  I’ve attached a copy to this post, but you can find additional copies (as well as versions of the definitive documents used to evidence these terms) here.

As always, if you’d like to discuss this post or your own company’s financing experiences please don’t hesitate to leave a comment down below or contact me at rhoeg@hoeglaw.com.

nvca-series-a-term-sheet

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