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18/06/2020
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by Michele Vitali

Funding Round Term Sheet 101 Series: Antidilution Protection

Antidilution in funding rounds - full ratchet and weighted average

In the second part of our funding round term sheet 101 series we take a closer look at antidilution protection. An antidilution clause protects investors from having their ownership diluted in a down round (i.e. if the valuation has decreased compared to the previous financing round) by the issuance of additional shares at the lower valuation for the existing shareholders. Depending on the terms of the provision and the scope of the down round, this may even allow the existing investor to increase his stake. In this context, the terms full ratchet antidilution, broad-based and narrow-based weighted average antidilution are often used. A full ratchet antidilution protects existing investors the most and the broad-based weighted average antidilution is more in the interest of the founders (whereas for the founders no antidilution clause is usually best).

The position of the shareholder (voting power / share of profit and liquidation) is strongly determined by the size of the shareholding in the company (i.e. number of shares in relation to the total share capital). A capital increase therefore always entails the risk of dilution of voting rights in addition to dilution of capital. Swiss corporate law gives existing shareholders the right to maintain the current level of participation with a so-called subscription right (Bezugsrecht) (Art. 652b CO). To this end, when issuing new shares, the company must in general always offer new shares to existing shareholders first (of course there are exceptions to this principle). This right is not mandatory and the existing shareholders can waive their subscription rights. Especially in the case of early stage investments, existing shareholders and the early stage investor forego their subscription rights in favour of new investors in the next financing round. In addition to the statutory subscription right, investors often seek additional antidilution protection by way of an antidilution clause.

 

Antidilution protection

First of all, it should be noted that the antidilution clause is a very important but also a complicated and technical provision. The antidilution provision is predominantly in the interest of the investor and often not used in early stage investments. In simple terms, the antidilution provision protects the investors in the event the company issues shares at a lower valuation than in previous financing rounds (a down round).

Any issuance of shares is technically going to be dilutive because it will further divide the pie and lower the stake of the original shareholders / investors. However, where a financing round occurs at a higher valuation, new investors will get a smaller stake in the company than earlier investors for the same price, while a financing round at a lower valuation allows new investors to acquire a larger stake with a smaller investment than earlier investors. The dilution would therefore be disproportionate as the new investor was not only able to acquire more shares for less money, but the investment of the old investor lost additional value due to the down round (i.e. if the valuation has decreased compared to the previous financing round).

 

The two varieties: Weighted average antidilution and full ratchet antidilution

In order to protect the early investors from dilution in a down round, antidilution provisions provide that existing investors receive additional shares to make up for the fact that they 'overpaid' in a previous financing round. There are different ways to calculate this 'compensation' of early investors, and the fine print really matters here as it can have a very material impact on the cap table. There are two varieties: weighted average antidilution and full ratchet antidilution.

In a full ratchet world, the price per share paid by the early investor is effectively reduced to the price of the new issuance. Thereby, the full ratchet provision ensures that current investors are able to maintain (or even increase) their percentage of ownership (or as good as) in case of a future down round. However, if a company sold one share of its stock to someone for a price lower than the previous round, all of the previous round shares would be repriced (virtually) to the new issuance price and additional shares would have to be issued (usually at par value) to reflect this.

The weighted average antidilution on the other hand uses a relative (weighted) formula in a down round to virtually reduce the price per share paid by the early investor relative to the price of the new issuance but also taking into account the number of shares issued in the down round (there are differences in the formula for calculating the WAIP). Weighted average is a method of finding the average value of a group of numbers, which takes into account how many times each number occurs. This means that the weighted average issue price (WAIP) not only takes into account the issue price of the new shares but also the amount of shares issued relative to the previous financing round. As you can see from the formula bellow, the "total number of shares" has a significant impact on the weighted average price.

Weighted average price = (first price x shares) + (second price x shares) / total number of shares 

As a result of its relative formula (which we will explain in the example bellow), weighted average antidilution produces a smaller adjustment than the full ratchet antidilution. In the narrow-based weighted average formula, the total number of shares issued is lower (i.e. reserved but unissued shares are generally excluded) than in the broad-based formula. As a result, compared to the broad-based weighted average antidilution, existing investors are issued slightly more so-called antidilution shares and the founders are thus more diluted.

Today, the weighted average antidilution is the most common antidilution provision and we consider it market standard.

 

Practical examples for weighted average antidilution and full ratchet antidilution

In the following, we provide a few examples to illustrate the concept, the idea and the differences between weighted average antidilution and full rachet antidilution

Example:

An investor owns 10% of a company with a post-money valuation of CHF 5'000'000.

Valuation of the Company = 5'000'000

ShareholderNumber of SharesInvestmentShare %
Founder 145'000 45.00%
Founder 245'000 45.00%
Investor 110'000CHF 500'00010.00%
Total100'000CHF 500'000100.00%

After the next financing round, in which the original investor did not participate, the company is valued at CHF 25'000'000 after a CHF 5'000'000 investment (i.e. post-money) by a new investor. The stake of the original investor thereby decreased by 2% to 8%.

Valuation of the Company = 25'000'000

ShareholderNumber of Shares Investment Share %
Founder 145'000 36.00%
Founder 245'000 36.00%
Investor 110'000CHF 500'0008.00%
Investor 225'000CHF 5'000'00020.00%
Total 125'000CHF 5'500'000100.00%

In this scenario, the stake of the investor was diluted to 8%. However, since the value of the company increased to CHF 25'000'000, his stake is now worth CHF 2'000'000 (CHF 25'000'000*8%) compared to CHF 500'000 before the new financing round (CHF 5'000'000*10%).

However, in a down round the value of the investment of the early investor decreases. If the value of the company decreased to CHF 3'000'000 (post-money), a new investor investing CHF 500'000 will receive a 16.67% stake of the company for his investment (CHF 500'000/CHF 3'000'000).

Valuation of the Company = 3'000'000

Shareholder Number of Shares Investment Share %
Founder 145'000 37.50%
Founder 245'000 37.50%
Investor 110'000CHF 500'0008.33%
Investor 220'000CHF 500'00016.67%
Total120'000CHF 1'000'000100.00% 

Due to the lower valuation of the company, the new investor received twice as many shares for the same investment amount of CHF 500'000. It is true that the stake of the first investor has only shrunk by 1.67% from 10% to 8.33%. However, the investment has lost significant value. The original investment of CHF 500'000 is now only worth CHF 250'000 (8.33% of CHF 3,000,000), i.e. his investment has lost 50% in value.

If the parties would have agreed on a form of antidilution protection, the original price paid by the early investor for his shares is to be changed virtually, in order to determine how many new (so called) antidilution shares the early investor gets in order to reduce his dilution.

 

Variation 1: Example with a full ratchet antidilution protection:

In this scenario, the same original investor managed to negotiate a full ratchet antidilution protection. The company value again decreased to CHF 3'000'000 (post-money). A new investor investing CHF 500'000 will also receive a 16.67% stake of the company for his investment (CHF 500'000/CHF 3'000'000). The price per share paid by the new investor is only CHF 25 compared to CHF 50 per share paid by the original investor.

Valuation of the Company = 3'000'000

ShareholderSharesInvestment Share %
Founder 145'000 37.50%
Founder 245'000 37.50%
Investor 110'000CHF 500'0008.33%

Investor 1

(antidilution shares)

xyz
Investor 220'000CHF 500'00016.67%
Total120'000CHF 1'000'000100.00%

With a full ratchet antidilution, the price per share paid by the original investor is virtually changed to the price paid by the new investor (i.e. CHF 25). The new investor will therefore be issued additional 10'000 antidilution shares at nominal value (e.g. CHF 2). In addition, the new investor receives an additional 2'005 shares for his investment of CHF 500'000 (so that his shareholding of 16.67% remains the same).

Valuation of the Company = 3'000'000

ShareholderSharesInvestment Share % 
Founder 145'000 34.09%
Founder 245'000 34.09%
Investor 110'000CHF 500'0007.58%

Investor 1

(antidilution shares)

10'000

CHF 20'000

(CHF 2 par value)

7.58%
Investor 222'005500'00016.67%
Total 132'005 100.00%

With the full ratchet antidilution provision, the old investor was able to increase its shareholding to around 15% by only investing an additional CHF 20'000. As a result, his stake is still worth (rounded) CHF 450'000 after the down round.

The weighted average antidilution formula is somewhat more complicated. Without going into the details of the formula, the number of anti-dilution shares the old investor receives when weighted average antidilution clause is agreed is calculated as follows:

Antidilution shares = (investment investor 1 / Weighted Average Issue Price) - Investor 1 shares

 

Variation 2: Example with a weighted average antidilution protection:

From the example above we know that the old investor invested CHF 500'000 and received 10'000 shares. To keep the example simple, we assume a WAIP of CHF 40.90. This leads to the following result (rounded):

CHF 500'000/CHF 40.90 – 10'000 = 2'225 antidilution shares

If the old investor makes use of his antidilution protection, the old investor has the right to subscribe for additional 2'225 shares at nominal value (e.g. CHF 2) which will be issued in the course of the second investment round. In addition, the new investor receives an additional 450 shares for his investment of CHF 500,000 (so that the new investors shareholding of 16.67% remains the same).

Cap table after the issuance of the antidilution shares

ShareholderSharesInvestmentShare %
Founder 145'000 36.68%
Founder 245'000 36.68%
Investor 110'000CHF 500'0008.15%

Investor 1 

(antidilution shares)

2'225

CHF 4'450

(CHF 2 par value)

1.81%
Investor 220'450CHF 500'00016.36%
Total122'225CHF 1'004'450100.00%

With the weighted average antidilution provision, the old investor was able almost maintain its stake (9.97% vs 10%). The investment of the original investor has nevertheless lost value. However, due to the additional 2'225 antidilution shares he received, his stake of 9.97% is now still almost worth CHF 300'000 compared to the to CHF 250'000 without an antidilution protection.

 

Conclusion

If the company loses value over time, new investors can buy into the company at a comparatively low price. If the existing investors do not make use of their subscription rights (or if these were excluded in advance), their share will lose disproportionately in value (in addition to the loss of voting power). An antidilution clause (whether full ratchet antidilution or weighted average antidilution) protects existing investors by (virtually) adjusting the originally paid issue price per share retroactively and allowing them to acquire additional antidilution shares with a nominal value as compensation.  This reduces dilution and their original investment loses less value.

Remember, in our last post, we talked about valuation and price and looked at how many shares an investor gets for his investment. Click here if you want to revisit the first post of the series.