What are anti-dilution protective covenants?

Anti-dilution protective covenants are commonly seen in preferred stock documentation.  The purpose of anti-dilution covenants is to protect early investors in the event of a “down round”.  A down round is when shares are sold for a lower price than that paid by investors in earlier rounds.  Anti-dilution covenants are a contract requiring the company to issue more shares to early investors if the company sells shares to later investors at a price below that paid by the earlier investors.  How many shares the earlier investors are entitled to depends on the formula in their anti-dilution covenant.  

There are three basic types of anti-dilution formulas: full ratchet, broad-based weighted average, and narrow-based weighted average.  

  • Full ratchet — Puts shareholders in the same position as if they had made their invest at the new lower price.  The conversion price is simply changed to the price of the down round.  This formula can result in significant number of shares issued to earlier investors, and make it very difficult to rise capital later on.  It was more common in the dot-com era, but not seen often now.
  • Broad-based weighted average — See the formula below.  This is the most common kind of anti-dilution formula, and is usually not objected to by later shareholders.  
  • Narrow-based weighted average — Usually yields a larger share adjustment than broad-based weighted average.  It is seldom seen now.                              

Broad-based weighted average formula for preferred stock:                            

The new conversion price, NCP, for shares with the anti-dilution right in case of a down round, is calculated as follows:

    NCP   =    CP     x    (CS   +   AC/CP)/(CS   +  AS),      where 

       CS   =    Common stock outstanding before the down round.

       AC  =   Aggregate consideration paid in the down round.

       CP   =   Conversion price before the anti-dilution adjustment.

       AS   =  Number of shares (on as-converted basis) issued in the down round.

To get a sense of how large an adjustment would be, the key term to consider is AC/CP.  This is the amount of shares that could be purchased with the new consideration if the new shareholders were buying in at the earlier, higher price.  Since CP is higher than that being paid in the down round, the term AC/CP, will be smaller than AS, the number of shares actualy being purchased in the down round.  Since the fraction (CS   +   AC/CP)/(CS   +  AS) is less than one, NCP, the new conversion price for earlier class of stock, will be lower than CP, what it paid.  Lower is good for earlier investors, because they will get more shares when it becomes time to convert their stock into common.

It is called weighted average, because the adjustment that early shareholders are entitled to is a function of shares outstanding and shares issued in the down round.  Note that the size of the down round — AS — must be fairly large relative to shares outstanding, and there needs to be both a fairly significant difference between the original price and the down round price for the anti-dilution adjustment to yield a lot of extra shares to the earlier investors.

Narrow-based weighted average formula for preferred stock:       

 (This is one example, there are variations.)

The basic narrow-based anti-dilution formula is as follows (there are many variations):

 The new conversion price, NCP, for shares with the anti-dilution right in case of a down round, is calculated as follows:

   NCP  =  X1 + X2/Y1 + Y2, where

     X1   =    Aggregate consideration paid for shares in the earlier round.

      X2  =    Aggregate consideration paid for shares in the down round.

      Y1  =    Number of issued shares of the earlier round outstanding .

       Y2  =    Number of shares issued in the down round.

In this formula you can play around with the numbers to see that, holding the price of the down round constant, the adjustment will be relatively greater if the down round is larger.

Take a simple case where there are 10 shares outstanding that were purchased for $10 ($1 per share).  Consider a down round for $0.5 per share, in Case 1, 10 shares are purchased for aggregate consideration of $5.  In Case 2, 20 shares are purchased for aggregate consideration of $10.  Case 1 yields an adjustment ratio of .67 , from [(10 +10)/(10+20)].  Case 2 yields an adjustment ratio of .75, from [(10 +5)/(10+10)]. 

Like I said, this formula is not commonly seen these days.

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