The most important clause to look out for in a dreaded “down-round”
A standard investor protection clause commonly found in most VC led term sheets is unfortunately likely to become more relevant than ever as we move into a challenging fundraising landscape. So now seemed a great time to dive in and unpack the ‘anti-dilution’ clause.
The anti-dilution provision is a right that usually applies to preferred shares. It’s something that is negotiated by investors to protect them from the “economic dilution” of the company raising money in the future at a lower price than they invested at (i.e. a “down round”). The impact that this provision will have on the company depends on how it is drafted. Generally, there are two main ways that an anti-dilution clause is drafted. We’ll look at them both here and work through an example scenario to show the impact.
A quick note before we start, economic dilution (which we are focused on here) in the event of a down round is very different from “percentage dilution” which happens whenever a company issues new shares at a new higher-priced round. Percentage dilution is not an issue and any investors will expect to take percentage dilution when they do not invest at a new round to protect their stake (often known as investing their “pro-rata amount”).
Example Scenario: Company X has raised the following Series A:
- Pre-money: £40,000,000
- Series A investment (Round size): £10,000,000
- Option pool: 100,000
- Fully Diluted share capital (pre the round, inclusive of options): 1,000,000
- Price per Series A share: £40.00
- Series A shares issued: £10,000,000/£40= 250,000
- Fully diluted share capital post the round: =1,250,000
- Post-money: £50,000,000
Company X then gets a term sheet for their Series B at the following terms:
- Pre-money: £30,000,000
- Series B investment (Round size): £15,000,000
- Price per Series B share: £30,000,000/1,250,000=£24
- Series B shares issued: £15,000,000/£24= 625,000
- Fully diluted share capital post the round = 1,875,000
- Post-money: £45,000,000
In this example scenario, Company X raised its Series A at a £40m pre-money valuation and went on to raise £10m at this valuation. For simplicity assuming one investor did the whole £10m, this investor in our scenario paid a price per share of £40. Taking into account the shares issued at the round, Company X has a post-money valuation of £50m.
Company X then goes on to raise its Series B. However, market conditions have worsened and whilst Company X needs a minimum of £15m funding it's only able to command a £30m pre-money valuation from the market. As a result, the 625,000 shares issued to the Series B investor (again, for simplicity, assuming a single investor) are issued at a price per share of £24. The £24 share price is lower than the price paid at the last round and therefore Company X has had a “down-round”. To look at it another way, this means the £10m invested by the Series A investor has gone from being worth £10m priced at the last round to now worth £6m (250,000*£24).
Once there’s a down-round this is where the anti-dilution provision kicks in. The full impact of the provision depends on if a “full-ratchet” or a “weighted average price” mechanism has been specified in the drafting.
The full-ratchet mechanism aims to fully compensate the earlier investor (in our case the Series A investor) and effectively put them in the position they would have been in had they invested at the lower price per share of the Series B round. So, if the Series A investor had acquired shares at the £24 price per share they would have received 416,666 shares (£10,000,000/£24)(rounded down to the nearest whole share). Therefore, applying the full-ratchet mechanism on the closing of the new Series B round, the Series A investor would receive 166,666 (416,666–250,0000) free shares. These 166,666 shares, assuming a £24 price per share, would represent full economic compensation for the £4m difference in value between the value of the Series A investor’s position at the Series A (£10m)and what it is now worth at the Series B (£6m).
In the VC market, this mechanism is highly unusual and definitely not founder-friendly. We’ll show the difference between applying the full-ratchet compared to weighted average price at the end of the post to show this.
Weighted average price
The weighted average price mechanism attempts to apply weighting to provide for how impactful the new round is on previous investors. Hence, it’s considered a more balanced mechanism compared to the full ratchet and a more common approach in VC financings. Even within the weighted average price mechanism, there are two different ways that this can be calculated but will get to that shortly. To start with let's unpack the overall formula:
WAP = [(PPS(Series A) x SPM) + (PPS(Series B) x SN)] / (SPM + SN)
This looks like a scary formula but stick with me and we’ll break it down. Firstly, what do all these letters mean:
- WAP = weighted average price
- PPS (Series A) = price per share at the Series A
- SPM = Total number of shares pre-money (i.e. before this new Series B down-round)
- PPS (Series B) = price per share at the Series B
- SN = New Series B shares issued at the Series B
As mentioned above, there are two different applications of the weighted average price mechanism:
- the narrow-based weighted average (‘NBWA’); and
- the broad-based weighted average (‘BBWA’).
The narrow version only takes into account shares actually issued at the time and the broad version also adds on any options etc. and is therefore based on the fully diluted capital of the company at the time. Applying the numbers from the example scenario we can see the difference between the two:
- NBWA = [(£40.00 x 900,000)+ (£24 x 625,000)] / (900,000 + 625,000) = £33.44*
- BBWA = [(£40.00 x 1,000,000)+(£24 x 625,000) / (1,000,000+625,000) = £33.85
Using the NBWA each Series A share has been economically diluted by £6.56 (£40 - £33.44) and in the BBWA by £6.15 (£40 - £33.85). Thus the BBWA mechanism is less dilutive for Ordinary shareholders and hence considered more founder-friendly.
Having obtained the weighted average prices for each we can now calculate how many shares the Series A investor would have received if they’d paid each respective price and hence calculate how many shares they would be due applying the anti-dilution mechanism.
- How many shares they would have received total (NBWA): £10,000,000 / £33.44 = 299,043 shares (rounded down to nearest whole number)
- How many shares they would receive applying the anti-dilution mechanism (NBWA) = 299,043 - 250,000 = 49,043
- How many shares they would have received total (BBWA): £10,000,000 / £33.85 = 295,420 shares (rounded down to nearest whole number)
- How many shares they would receive applying the anti-dilution mechanism (BBWA) = 295,420 - 250,000 = 45,420
The difference between Full-ratchet, NBWA and BBWA is significant as shown by this table of the amount of anti-dilution shares an investor would receive applying each different mechanism:
The vast majority of VC led rounds that I see in the market contain the BBWA approach to anti-dilution and this is definitely the market standard. It is highly unusual to see full-ratchet and if it’s included and there is a down-round then the impact can be catastrophic in terms of founder dilution (just look at those numbers in the table above!). However, in more challenging market conditionsterms that were previously considered standard can have a way of changing. Therefore, understanding how the different versions of an anti-dilution clause work can be of massive importance.
*Note: here I have rounded to two decimal places for the purposes of this post. However, an alternative approach is not to round here at all and use the raw number for the purposes of the ongoing calculations. This would lead to a different number of anti-dilution shares at the end. As with any calculation like this, it’s important to be clear on the method of rounding used and agree that between the relevant parties.