It's (Almost) All About Anti-Dilution
It's always about enterprise valuation.  If you ask any participant in a venture deal the first deal term anyone wants to talk about is:  What's the "pre-money valuation." Don't get us wrong, the "pre-money valuation" is crucial and often times a deal breaker. Pre-money valuation is an important term because it establishes what (puts a stake in the ground)  the baseline exit will (or might) look like (how much on a percentage basis everyone gets).  But it is only part of the story.  As we have said before, the other terms really do matter.  A pre-money valuation of $5 million with onerous terms may be more harmful to a company and its shareholders than a pre-money valuation of $3 million with less onerous terms.

The point is that other terms really do matter, and one term that deserves a lot of attention is anti-dilution protection.  If the pre-money valuation is the price, anti-dilution is the price guarantee (in the case of full ratchet anti-dilution) or price protection in the case of weighted average.  Anti-dilution provisions can have a tremendous impact on a company (and in particular its founders and option holders) especially in the event of a subsequent "down round" of financing Anti-dilution protection is perhaps the most important deal term beyond valuation, but it is often misunderstood.  To get a better picture of what anti-dilution means, we need to drill down on what is meant by dilution.  In the context of a typical venture deal, the term dilution refers to economic dilution, not straight percentage dilution.  For example, assume that a company is capitalized with 100 shares of common stock outstanding where there are two shareholders and each shareholder paid $1.00 per share.  The value of the company is $100.  Let's say that each shareholder owns 50% of the company.  So each shareholder has 1/2 of $100 company or $50 in "value."  Now the company undergoes a subsequent financing, where it sells an additional 100 shares at $2.00 per share to a third investor.  Now the original 2 shareholders have 25 percent of the company.  As a matter of percentage dilution, each has been diluted by half.  However, as a matter of economic dilution, each is better off.  There is no economic dilution.  Each of the original two stockholders owns 50 shares that pre-financing were worth $50, which now on a post financing basis are worth $75 because the enterprise valuation is now $300. Anti-dilution provisions are intended to provide investors with an element of "downside protection" in the event that a company "sells" additional securities at a lower price than the securities previously purchased by such investors.  Anti-dilution provisions enable the conversion price of such investor's securities to be adjusted downward so that upon conversion to common stock the investors are entitled to receive additional shares of the company's common stock.  How many more shares depends on the type of anti-dilution formula which exists in the company's charter.  Anti-dilution formulas generally fall into two categories: (1) full ratchet anti-dilution, and (2) weighted average anti-dilution.  The differences between these types of anti-dilution provisions and their potential impact are described in more detail below.

Full Ratchet Anti-Dilution
A full ratchet anti-dilution formula provides that the conversion price of an investor's securities will be automatically decreased, upon the issuance of additional securities, to the same price that such additional securities are "sold" by the company. The conversion price is the price by which one share of preferred stock (using preferred as the convertible security) converts into common stock, by dividing the original issue price (the price an investor paid for a share of preferred stock) by the conversion price.  The lower the conversion price, the more shares of common stock one share of preferred stock will convert into.  A typical full ratchet anti-dilution provision would read as follows: "In the event this Corporation shall issue Additional Shares of Common Stock (including Additional Shares of Common Stock deemed to be issued) without consideration or for consideration per share less than the applicable Conversion Price in effect on the date of and immediately prior to such issue, then and in such event the Conversion Price of the Series A Preferred shall be reduced, concurrently with such issue, to the lowest price at which any of the Additional Shares of Common Stock are issued."An example of the effect of a full ratchet anti-dilution formula is as follows:  Investor A purchased 1,000,000 shares of Series A Preferred Stock of Company X at $1.00 per share at a pre-money valuation of $3,000,000 for a 25 percent stake, on a post-financing basis ($4,000,000), in Company X (we assume as is usually the case each share of Series A Preferred initially converts into one share of common stock).  One year later, Company X sells 1,000,000 shares of Series B Preferred Stock at $0.50 per share (again convertible one-to-one into common) at a pre-money valuation of $2,000,000 for a 20 percent stake, on a post-financing basis ($2,500,000), to Investor B.  With no anti-dilution protection, Investor A would own 20 percent of Company X after the sale of the Series B Preferred Stock (1,000,000 shares out of 5,000,000 shares).  However, the full ratchet anti-dilution provision in Company X's charter provides that the conversion price for the Series A Preferred Stock that Investor A purchased for $1.00 per share will be reduced to $0.50 per share, such that upon conversion, Investor A would be entitled to receive 2,000,000 shares of Company X common stock upon conversion rather than 1,000,000 shares.  What will really happen is that Investor B will take into account this anti-dilutive effect into its term sheet to allow it to maintain its percentage interest at 20 percent, thus further crushing Company X's founders and holders of common stock (including optionees).  However, the real issue here is that full rachet adjusts the Series A Preferred Conversion price regardless of the number of shares of Series B Preferred actually sold at the dilutive price.  Therefore, the issue is one share of Series B Preferred issued at $0.50 per share will have the same impact on the Company from an ant-dilution adjustment standpoint.

Weighted Average Anti-Dilution
There is also weighted average anti-dilution protection, which is divided into two categories: (1) broad-based weighted average anti-dilution protection, and (2) narrow-based weighted average anti‑dilution protection.   Weighted average anti-dilution protection is a more moderate type of anti-dilution provision than full ratchet, where an investor's conversion price is decreased, and thus the number of shares of common stock received on conversion is increased.  A weighted average anti-dilution formula takes into account both:  (a) the reduced price and, (b) how many shares are issued in the "down round" of financing. 

Both of these types of weighted average anti‑dilution provisions provide that the conversion price of an investor's securities will be reduced upon the issuance of additional securities at a price less than such securities.   A typical broad-based anti-dilution provision would read as follows: "In the event this Corporation shall issue Additional Shares of Common Stock (including Additional Shares of Common Stock deemed to be issued) without consideration or for consideration per share less than the applicable Conversion Price in effect on the date of and immediately prior to such issue, then and in such event the Conversion Price of the Series A Preferred shall be reduced, concurrently with such issue, to a price (calculated to the nearest cent) determined by multiplying such Conversion Price by a fraction, the numerator of which shall be the number of shares of Common Stock outstanding immediately prior to such issue (including all shares of Common Stock issuable upon conversion of the outstanding Preferred Stock) plus the number of shares of Common Stock which the aggregate consideration received by the Corporation for the total number of Additional Shares of Common Stock so issued would purchase at such Conversion Price; and the denominator of which shall be the number of shares of Common Stock outstanding immediately prior to such issue (including all shares of Common Stock issuable upon conversion of the outstanding Preferred Stock) plus the number of such Additional Shares of Common Stock so issued (or deemed to be issued)." An example of the effect of a broad-based weighted average anti-dilution formula is as follows:  Investor A purchased 1,000,000 shares of Series A Preferred Stock of Company X at $1.00 per share at a pre-money valuation of $3,000,000 for a 25 percent stake, on a post-financing basis, in Company X.  One year later, Company X sells 1,000,000 shares of Series B Preferred Stock at $0.50 per share at a pre-money valuation of $2,000,000 for a 20% stake, on a post-financing basis, to Investor B.  Again, with no anti-dilution protection, Investor A would own 20% of Company X after the sale of the Series B Preferred Stock (1,000,000 shares out of 5,000,000 shares).  However, the broad-based weighted average anti-dilution provision in Company X's charter provides that the conversion price for the Series A Preferred Stock that Investor A purchase for $1.00 per share will be reduced to $0.90 per share, such that upon conversion, Investor A would be entitled to receive 1,111,111 shares of Company X common stock rather than 1,000,000 shares.  While Investor B will take into account this anti-dilutive effect into its valuation so as to maintain its 20 percent stake in the company on a post‑financing basis, you can clearly see that this will have a much less punitive effect on the company's founders and management than a full ratchet anti-dilution provision will have. A typical narrow-based anti-dilution provision would read as follows: "If and whenever the Corporation shall issue or sell, or is deemed to have issued or sold, any shares of Common Stock for a consideration per share less than the then applicable Conversion Price for the Convertible Preferred Stock in effect immediately prior to the time of such issue or sale, then, forthwith upon such issue or sale, the Conversion Price for the Convertible Preferred Stock shall be reduced to an amount equal to the following the quotient obtained by dividing the total computed under clause (A) below by the total computed under clause (B) below as follows:   (A) an amount equal to the sum of (1) the aggregate purchase price of the shares of the Convertible Preferred Stock sold pursuant to the Stock Purchase Agreement, plus (2) the aggregate consideration, if any, received by the corporation for all Additional Stock issued on or after the date of the Stock Purchase Agreement at a per share price below the then applicable Conversion Price; (B) an amount equal to the sum of (1) the aggregate purchase price of the shares of Convertible Preferred Stock sold pursuant to the Stock Purchase Agreement divided by the applicable Conversion Price for such shares in effect on the date of the Stock Purchase Agreement, plus (2) the number of shares of Additional Stock issued since the date of the Stock Purchase Agreement at a per share price below the then applicable Conversion Price."  Using the same example above, a typical narrow based weighted average anti-dilution formula would provide that the conversion price for the Series A Preferred Stock that Investor A purchased for $1.00 per share will be reduced to $0.75 per share, such that upon conversion, Investor A would be entitled to receive 1,333,333 shares of Company X common stock rather than 1,000,000 shares. Now don't get us wrong, while anti-dilution protection can clearly have potential punitive effects on management and/or a founder's percentage interest in a company, it is a very standard and common provision for a venture capital investor to seek.  Remember that anti-dilution provisions only kick in when the pre-money valuation of a company in a future round of financing (or other issuance of the company's securities which are not excluded from such formula)  is less than the post-money valuation in one of the company's previous rounds of financing, so the anti-dilution provision is "protecting" such investor's investment.  There can be a number of reasons why a company's valuation would be less today than it was 6 months or even one year ago, for example, market conditions change, the company fails to execute on its business plan or unforeseen events occur, so it's extremely commonplace for an investor to be somewhat protected on the "downside."  What level of "downside" protection is what really should be the focal point of the discussion. The above examples clearly demonstrate the differing effects that the varying anti-dilution provisions can have on a company's founders and holders of common stock, in the event of a "downround" of financing.  So, when negotiating a venture capital term sheet, management should be mindful of the effects of anti-dilution provisions and focus on the potential impact of such provisions on the company, particularly in light of valuation discussions.