Raising a Down Round: Anti-Dilution Isn’t as Bad as Going Out of Business
In a market like the one we’re now in, you know fundraising is going to be challenging and you never know how long the downturn will last. Will it look like 2000 where the nuclear winter lasted three years after the dot com crash? Will it resemble 2008, the Great Financial Crisis that lasted 18 months? Or, will it be more like the COVID-19 selloff that lasted two months, but was historically steep and deep?
Amid the uncertainty, we believe two things will be true. First, while you can’t control the future or the fundraising environment, you can manage and control the amount of capital you choose to raise, your level of burn, and your cash runway.
Second, terms matter. The anti-dilution provisions you agreed to in your last raise or note may now be a critical consideration as you think about fundraising strategies and the impact of dilution on your company’s cap table, especially in a down round. Rarely do founders think they’ll need to consider or be subject to the anti-dilution provisions in their term-sheets and funding documents. Unfortunately, many founders are about to find out how painful those terms can be in a down round. How big the impact will be, will depend on each company’s specific situation.
Our collective advice at Bullpen having co-founded almost 20 companies including Electronic Arts, Aggregate Knowledge, Zynga and Madison Reed, is act fast and decisively to manage your burn, reduce expenses and extend your cash runway. Take the extra capital if it’s available at slightly better terms than the last round or the same terms. You may even consider raising capital in a down round and at a lower valuation than your previous round. And, depending on the circumstances you may be evaluating the trade-offs between additional dilution from a new fundraising and the risk your company runs out of cash.
Now, go pull out your financing documents and review your anti-dilution provision. The fine print for your specific terms is what matters here.
Nuts and Bolts of Anti-Dilution
The main takeaway from having done a down round while CEO, is that anti-dilution gets more painful based on the amount of money raised in the new round, NOT the delta in the new valuation. We are going to walk through why this is the case with explanations of the math as well as some examples. We will also leave you with a little calculator that will help you play out scenarios for your own company.
It’s important to recognize that while anti-dilution mechanisms can range from full ratchet provisions (most investor-friendly) to broad-based weighted average (most company friendly), the vast majority of deals will use the Broad-based Weighted Average formula. In fact, we haven’t seen a full ratchet provision in more than 10 years, so we’ll assume that everyone is operating under the broad-based weighted average formula.
We also need to be careful and avoid some common misconceptions around anti-dilution adjustments. A few thoughts on that below:
A “down round” is a financing in which a company sells shares of its preferred stock at a price per share that is lower than the price per share paid in the previous round. Translation: Important that we think in terms of “per share price” for purposes of anti-dilution provisions.
The actual anti-dilution adjustment is function of both the “per share price” and the “amount raised”. This means cap tables are helpful, but the other details need to be understood and they will be very company-specific.
The company’s charter or amended and restated Articles of Incorporation will include the exact anti-dilution language, but the typical anti-dilution adjustment formula is as set forth below (broad-based weighted average formula).
This is important! While anti-dilution is a key investor protective provision, most people believe that an anti-dilution adjustment involves the issuance of additional preferred shares, which is NOT the case. Rather, it involves an adjustment to the conversion ratio which results in the issuance of additional common shares upon conversion of the underlying preferred stock. By design, this helps to avoid the unnecessary problems associated with issuing additional shares without consideration and it also preserves and/or results in no change to the negotiated liquidation preferences.
Broad-based Weighted Average Formula
This form of investor protection adjusts the conversion ratio based on the decrease in the value of the shares caused by the down round (lower price per share). A typical broad-based weighted average anti-dilution formula is as follows:
CP2 = CP1 * (A+B) ÷ (A+C)
CP2 = Conversion price after down round
CP1 = Conversion price before down round
A = Fully-diluted capitalization of the company prior to the down round, including the assumed exercise of outstanding options and warrants and conversion of preferred stock to common, but not giving effect to any securities converting in the down round
B = Total consideration received by the company in the down round divided by the Series A per share purchase price
C = Number of shares of stock issued in the down round
The new conversion price is then divided into the original issue price to arrive at the new conversion ratio. As we know, the typical deal specifies a conversion price for preferred stock equal to the original issue price divided by the conversion price and originally the original issue price and the conversion price are the same, meaning preferred converts to common on a 1:1 basis. In a down round, the effect of the anti-dilution adjustment is to reduce the conversion price (CP2), which increases the conversion ratio from 1:1 to something higher, e.g., 1:1.2 or 1:1.3, etc. In essence, the investor is made whole to reflect the benefit of hindsight or changes in valuation based on events that did not materialize or that changed following the initial investment. Again, this is an investor-friendly term.
Examples
Let’s assume you’ve raised one $10M round of financing at a pre-money valuation of $40M and a post-money valuation of $50M. Let’s look at three different scenarios at two different prices.
You will see that the extra shares of anti-dilution are not near as bad as probably thought across the board. While they become more noticeable at the bottom of the table, their total effect is much smaller than the dilution from the new round of capital. Further, you see that the relative change in valuation is less important than the total money raised at the new price. The simple intuition here is that size matters! If you were to sell JUST ONE SHARE at the new lower price, the impact of broad-based weighted average anti-dilution provisions is not the worst thing.
So while your company needs to understand that a down round can carry psychological damage and be a blow to employee morale, anti-dilution provisions are “non-linear” and may NOT have as negative an impact as you think. So in keeping with the theme of times are tough, cash is your most precious asset, and we don’t know how deep or how long this period of uncertainty and negative investor sentiment may last, it may be ok to take new money at a price lower than the last round if the amount of capital under discussion is reasonable or small.
Again, our goal and message to our portfolio companies and readers is to:
- Bolster and protect cash position
- Manage and control spending and cash burn to extend runway
- Assume investor sentiment and market conditions don’t improve for 18–24 months
