Decoding the investment term sheet can be a daunting task for young entrepreneurs when all they want to do is work on their product or service. In fact, in a rush to close a deal and get money in the company’s bank account, entrepreneurs spend less time understanding what they are signing on. Of course, there are lawyers involved but some do not bother explaining the key terms and clauses (mostly because they are working on very subsidised fees). While it is difficult for startups to really negotiate during early-stage deals, it is important to at least know and understand the consequences of what may happen if things get bitter. For instance, who would not like investors to invest in their company at high valuations? But what happens when the valuation is so inflated that the next round cannot match that and the new investor decides to bring a “reality check”? Most entrepreneurs, in my experience, do not want to think about this… till they are made to.
Anti-dilution is one such clause which is present in all financial investment agreements. It is important that founders understand what it means even though it is drafted in an extremely complex and convoluted manner. The present article discusses just that and while it may not be possible to cover every detail pertaining to an anti-dilution, our attempt is to simplify its understanding as much as possible.
What is anti-dilution?
Simply put, anti-dilution safeguards an investor from any dilution of his investment during subsequent rounds of funding by a new investor. This protection is ensured by adjustment to the issue price and issue of additional shares to the “earlier” investor. The underlying objective is to protect the rights of the existing investor despite the downward trend in valuation of the investee entity. Anti-dilution can be of two types, namely (i) full ratchet and (ii) weighted average. Each has a very different impact on the shareholding pattern post its exercise.
Full ratchet: A full ratchet anti-dilution protection is often criticised to be one-sided and harsh for the startup founders. Full ratchet provision requires that if any share (equity or preference) sold in a subsequent investment round is at a lower issue price than what the existing investor paid, the value of the existing investor’s shares will be repriced to tally with the new issue price. Accordingly, fresh shares will be issued for the surplus of the consideration remaining after such price adjustment without any further payments. Complicated? Let us understand it with a practical illustration.
Illustration 1: The promoters of a company hold 1,500 shares in it which constitutes its 100% shareholding. A Series A investor now invests INR 1,000,000 for 1,000 shares at INR 1,000 per share at a post money valuation of INR 2,500,000 and acquires 40% stake. The promoters continue to hold the remaining 60% shares, that is, 1,500 shares. Now, at the time of raising a Series B round, the valuation drops significantly and the Series B investor infuses INR 500,000 for 50% of the investee company at a post money valuation of INR 1,000,000 and is allotted 2,500 shares. The balance 50% or 2,500 shares are held by the promoters and the Series A investor. Based on this, the value of each Series B share will be 500,000/2,500, that is, INR 200 per share. This means that Series A investor invested INR 800 more for each share than the Series B investor, in which case the full ratchet protection will trigger. In such a scenario, the shares of the Series A investor will be revised downward to INR 200 per share instead of its original price of INR 1,000 per share. Consequently, the Series A investor will be issued additional 1,000 shares for maintaining its shareholding percentage at 40%. The trickle-down effect will be that promoters’ shareholding will get extensively diluted to such extent that he will merely hold 1,500 shares amounting to 10% as opposed to 30%, which should have been the case after the Series B funding round. Now, post the exercise of the full ratchet, the promoters will hold 10% in the company, the Series A investor 40% and the Series B Investor 50%.
Weighted average: A weighted average adopts a less harsh stance and is guided by a formula for adjustment of price giving due consideration to the outstanding shares and shares already held by the existing investor. Herein, if the company brings further investment at a lower valuation, the price is adjusted by a weighted average of existing price, number of outstanding shares, number of shares to be issued in the proposed investment, and the aggregate consideration received.
The formula followed is: New Conversion Price (say CP2)=Existing Conversion Price (i.e. the price immediately before the new issue) (say CP1) * (A+B)/(A+C), where
- A is the number of shares outstanding before the new issue including equity shares resulting from conversion of convertibles and exercise of options; but it excludes any equity shares entitlement of the new investor;
- B is the number of shares that the company should have issued to the new investor for the aggregate consideration received factoring CP1, that is total consideration received from second investor/CP1; and
- C is the number of shares to be issued in the proposed investment round.
Illustration 2: To apply weighted average in Illustration 1 facts
(i) CP1 will be INR 1,000 per share for 1,000 Series A shares representing 40% of the investee company.
(ii) A will be the sum total of 1,000 Series A shares and 1,500 shares held by the promoter, that is 2,500 shares.
(iii) B will be 500,000/1,000, that is 500.
(iv) C will be 2,500 Series B shares resulting in 50% of shareholding.
Accordingly, CP2=1,000 * (2,500+500)/(2,500+2,500), which equals to INR 600 per share. On the basis of this new conversion price of INR 600, Series A investor will be entitled to an additional 667 shares (approximately). This means that the Series A investor’s shareholding will be reduced to 33.33% from 40%, whereas the promoter’s holding will be reduced to 16.67% from 30%.
What is better?
To summarise, in full ratchet, the existing investor maintains its shareholding and the promoters get significantly diluted. In case of weighted average, both, the existing investor and the promoters, get diluted by certain percentages. Most investors like to push for a full ratchet in their funding agreements but founders do manage to negotiate this. Of course, if it is deal breaker, a more practical call has to be taken. The kind of anti-dilution clause preferred by investors will largely depend on the sector of investment, inherent risks and, of course, the startup’s founders and management team.
As a general restriction, it is extremely fair since it motivates founders to work hard to achieve the targeted results as well as realise that inflated valuations may not necessarily benefit in the long run. Founders should always remember that a lower but growing valuation is likely to reap higher returns as opposed to a one-time leap.