This article looks at protections that may be negotiated by minority investors to avoid or limit the damage of equity dilution. The number of investments in which private equity or venture capital funds have minority shareholdings is increasing. Early or mid-stage venture deals are long-standing examples of such deals, but the recent surge in the quantum of co-investments is also increasing the popularity of minority interests. As a result, anti-dilution protection is back on the agenda.
The purpose of anti-dilution rights is to protect the value of an investor’s stake. The level of protection that an investor may require will depend on several factors, including the valuation of the company at the time of its investment and the perceived exposure to further financing requirements. But negotiating effective anti-dilution rights is a tricky business, and it can be exacerbated when the parties drop complex mathematical formulae into the investment agreement without having fully gauged the potential real-world effects of those formulae.
Methods of anti-dilution protection
Two methods commonly used to obtain anti-dilution protection are:
- Bonus shares: the investor receives bonus shares to protect its stake. But there have to be distributable profits or reserves to pay up the bonus shares. Alternatively, the investor may have the right to subscribe for bonus shares at nominal value. Bonus issues must be excluded from pre-emption rights.
- Conversion rate: the investor holds preferred shares convertible into ordinary shares at an applicable conversion rate. If a down round occurs, the conversion rate is adjusted to more than 1:1 to account for the dilutive effect of the down round.
- There are pros and cons to both methods:
- Multiple series of down rounds can be more difficult to track by conversion.
- The eventual capitalisation only becomes clear after conversion has occurred.
- Bonus issues are generally more transparent than conversion; a new capitalisation table is available at the time of the down round.
- The optical transparency of a bonus issue may demotivate management.
Full or weighted-average ratchet
Whichever method is used, the parties must also agree a suitable ratchet. There are several variations, offering different degrees of protection.
In a full ratchet, the investor receives additional shares (or the right to convert preferred shares) that, in effect, allows him to maintain his full percentage ownership at the same level or same value in down rounds. The investor’s effective purchase price always equals the lowest price that the company sells its stock for in the dilutive round. The outcome is the same regardless of how much new money the company raises in a down round.
A weighted-average ratchet applies a formula that is based on the interplay of several variables, including the number of shares outstanding, the price at which they were sold, the amount being raised in the down round and the average price per share post-dilution (i.e., as if options, including employee options, performance stock reserved for managers, warrants and other securities had been converted). The formula produces a ratio that determines the number of ordinary shares (which will be greater than one) that the investor will receive for converting one preferred share.
The weighted-average ratchet is not as strict as the full ratchet: it provides some compensation for the dilution, but does allow the investor’s stake to fall. A full ratchet is worse for other shareholders because it shifts the costs of a decline in business value on to them. A full ratchet can therefore reduce the attractiveness of a company to outside investors in future financing rounds.
Partly for these reasons, weighted-average ratchets are more common. The investor receives some protection against dilution, but its ownership percentage can still fall. If a full ratchet is used, it may expire at the end of an agreed period or once a certain level of funding is achieved, after which the company would move to a weighted-average ratchet and/or pay to play (see below).
Broad or narrow weighed-average
In a weighted-average ratchet, there are different ways to arrive at the new conversion price, depending largely on which categories of securities are factored into the formula. A “narrow” weighted-average will exclude certain categories of security from the calculation, for example taking into account only options that are in the money, whereas a broader one will include more categories. The “narrower” the ratchet, the greater the upwards adjustment enjoyed by the investor class. The parties may also agree that certain new issues should not trigger the anti-dilution ratchet at all, e.g. shares issued under an employee option plan or performance ratchets for managers.
In general, the “broad” weighted-average ratchet is more commonly used than the “full” ratchet. Managers often argue for a broad weighted-average, but it may be the lead investor that has the main say on which approach and formula are used.
Pay to play
“Pay to play” means that the anti-dilution protection applies only to those investors who will participate in the next dilutive financing. It is a common solution to perceived ratchet injustices, and is sometimes linked to a broad ratchet where a syndicate of investors is comfortable with their initial valuation.
The basic idea of pay to play is that if a protected investor does not take up a pre-defined percentage of its entitlement to new securities in a down round, it loses some or all of its anti-dilution protection (the exact terms can be tailored to be more or less investor-friendly). The loss of protection is accomplished by converting the non-participating investor’s preferred shares into another class of preferred shares that have the same preferential rights to income, capital and dividends, but which have no anti-dilution protection (effectively, a pay to play class). Pay to play tends to encourage investors to participate during difficult financing rounds, in order to preserve their anti-dilution protection.
Some form of anti-dilution protection is normally provided to investors purchasing preferred shares at a higher price than the ordinary shares held by founders and management. The parties should be careful when agreeing on anti-dilution mechanisms. To be sustainable, an anti-dilution mechanism should be forward looking and balance the interests of investors and the company’s own likely future financing needs. But sometimes the chosen mechanism is only the starting point on negotiations with new investors in a subsequent round.