Wednesday, May 28, 2003

ANTI-DILUTION PRICE PROTECTION A common feature of Preferred Stock issued to venture capitalists in privately held companies is anti-dilution price protection (here’s a simplistic definition), an especially relevant concept with the prevalence of down rounds. Let’s say that the VC purchases 1,000,000 shares of convertible preferred stock at $1.00 per share. The VC can later convert the stock to an equal number of common shares. The VC makes this deal because he knows that 1,000,000 shares of common stock will be equal to about 50% of the company (assuming that there are currently 1,000,000 shares of common outstanding) or are otherwise worth about $1M.

Let’s then assume that the Company later issues 10,000,000 shares to the founder’s mom for $10,000. Now, if the VC converts his preferred stock to common, he’ll have only 1,000,000 shares of common stock when a total of 12,000,000 are outstanding. Well, that’s not 50% of the Company. So, to protect itself, the VC insists that the articles of incorporation provide for an adjustment in the shares issuable upon conversion if the Company issues stock to anyone else at a price lower than paid by the VC. This could take the form of a “full ratchet,” which would allow the VC to convert at a price per share equal to the lowest amount paid by a subsequent investor. In the example above, that would mean that the VC could get to convert his 1,000,000 shares of preferred stock to 1,000,000,000 shares of common stock (that’s $1,000,000 worth of stock priced at mom’s price of $0.001 per share). Obviously, the full ratchet penalizes any shenanigans by the Company.

The other type of anti-dilution price protection is the weighted average. There are a number of varieties of this, but the basic point is to adjust the price per share upon conversion to properly reflect the new price per share paid in, on average, by all shareholders. So, since the VC paid $1 per share, and mom paid $0.001 per share, we see that there are now 11,000,000 shares bought by the VC and mom for at total of 1,010,000. How much is that per share? $0.101 per share. So, the VC should be able to convert its $1 million worth of preferred stock to a number of common shares priced at about 10 cents a share. Thus, the VC gets about 10,000,000 shares. The same as mom. Well, that doesn’t seem fair, so there are a number of other ways that the calculation is done, but I don’t have the space to get into them. Anyway, later I will discuss a time when an investor may be wise to refuse anti-dilution price protection.


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