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The most common form of anti-dilution protection is called “weighted average” anti-dilution protection. “Weighted-average” anti-dilution is fairer than a full-ratchet as it looks at the dilutive impact of the shares issued in a down-round across a company’s share capital. Weighted average anti-dilution protection can either be “broad based” or “narrow-based”. “Broad-based”, (which is the most shareholder favourable) is calculated by reference to the company’s fully diluted share capital (that is, taking into account all options, warrants and any other convertible securities), whilst “narrow-based” anti-dilution protection looks at the issued share capital of a company only.
As with the full ratchet, depending upon the mechanic (either a bonus issue or conversion) being used the calculations are different, but the end result is the same. The basic calculations for both “broad-based” and “narrow-based” anti-dilution protection are as follows:
BONUS ISSUE
The number of anti-dilution shares to be issued equals:
((Investor’s Price Per Share/Weighted Average) * the number of Preferred Shares held by the Investor) – the number of Preferred Shares held by the Investor
The Weighted Average is calculated as:
(Investor’s Price Per Share * Number of shares in issue prior to the investment) + (the aggregate investment amount in the down-round financing)
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Number of Shares in issue prior to the investment + the number of shares issued in the down-round financing
CONVERSION
Conversion Ratio equals:
Number of shares in issue after the down-round investment (on an as-converted basis, but ignoring any issue of anti-dilution shares)
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(Number of shares in issue prior to the investment (on an as-converted basis) + (the aggregate total of the down-round investment/the Original Conversion Price))
The only difference between the “broad-based” and “narrow-based” calculation is what is included in the “Number of shares in issue prior to the investment” figure. In the “broad-based” calculation this figure would include all options, warrants, convertible securities, etc. and in the “narrow-based” calculation this figure would be the issued share capital only.
Broad-based Examples
For example (using the conversion mechanic), if a company has the following share capital structure:
5,500,000 Series A Shares, issued at £1 per share (this would also be the Original Conversion Price/Subscription Price)
6,000,000 Ordinary Shares
1,000,000 Options
In a down-round financing the company issues 6,666,667 Series B Shares at £0.60 per share for a total aggregate subscription of £4,000,000.
The Series A Shares would be adjusted as follows:
The Conversion Ratio would be 1.612, calculated as follows:
(12,500,000 (the sum of the Series A Shares, Ordinary Shares and Options) + 6,666,997 (the number of Series B Shares)
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(12,500,000+(4,000,000 (the total Series B investment)/1 (the Original Conversion Price)
The Series A Shares would convert into 6,388,889 (5,500,000*1.612) Ordinary Shares upon conversion of the Series A Shares (in any cap table the Investor’s shares would be represented as 6,388,889 on a fully diluted basis, notwithstanding that a conversion event has not occurred)
In the event that the bonus issue mechanic is used, the Investor would on completion of the down-round financing receive a bonus issue of 888,889 Series A Shares, calculated as follows:
(1 (the Series A Subscription Price)/0.8609 (the Weighted Average)) * 5,500,000 (the number of Series A Shares held by the Investor) – 5,500,000 (the number of Series A Shares held by the Investor)
The weighted average is calculated as follows:
(1 (the Series A Subscription Price )* 12,500,000 (the sum of the Series A Shares, Ordinary Shares and Options)) + 4,000,000 (the aggregate Series B investment amount)
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(12,500,000 (the sum of the Series A Shares, Ordinary Shares and Options) + 6,666,997 (the number of Series B Shares)
When the anti-dilution shares are added with his original shareholding the Investor would have a total of 6,388,889 Series A Shares.
Narrow-based Examples
Using exactly the same facts as above, the Series A Shares would be adjusted as follows:
The Conversion Ratio would be 1.1720, calculated as follows:
(11,500,000 (the sum of the Series A Shares and Ordinary Shares but excluding the Options) + 6,666,997 (the number of Series B Shares)
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(11,500,000+(4,000,000 (the total Series B investment)/1 (the Original Conversion Price)
The Series A Shares would convert into 6,446,237 (5,500,000*1.1720) Ordinary Shares upon conversion of the Series A Shares (in any cap table the Investor’s shares would be represented as 6,446,237 on a fully diluted basis, notwithstanding that a conversion event has not occurred)
In the event that the bonus issue mechanic is used, the Investor would on completion of the down-round financing receive a bonus issue of 946,237 Series A Shares, calculated as follows:
(1 (the Series A Subscription Price)/0.8532 (the Weighted Average)) * 5,500,000 (the number of Series A Shares held by the Investor) – 5,500,000 (the number of Series A Shares held by the Investor)
The weighted average is calculated as follows:
(1 (the Series A Subscription Price) * 11,500,000 (the sum of the Series A Shares and Ordinary Shares but excluding the Options)) + 4,000,000 (the aggregate Series B investment amount)
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(11,500,000 (the sum of the Series A Shares and Ordinary Shares but excluding the Options)) + 6,666,997 (the number of Series B Shares)
When the anti-dilution shares are added with his original shareholding the Investor would have a total of 6,446,237 Series A Shares.
As you can see, the calculations for the weighted average are more complicated than for full ratchet protection. Some VCs include the anti-dilution formula as a schedule to the term sheet which should be encouraged. You should ensure that (i) you understand how the formula works in practice and (ii) that the formula reflects market practice and is a true representation of the commercial agreement (as occasionally the calculations can be different).
The Anatomy of a Term Sheet series can be found in full here
