2. Anti-Dilution Provisions

2.1. Full Ratchet Anti-Dilution Provision

The full ratchet is very simple: In a down round, the conversion price of securities that are protected by a full ratchet is lowered to the price at which the diluting securities are issued. Formally, the number of securities that the protected shareholders will hold after triggering the ratchet is computed as follows:

 

\( \text{New number of shares} = \text{Original number of shares} \times \frac{\text{Original purchase price}}{\text{New issue price}} \)

   

Let's look at this with a simple example. Suppose a firm has the following ownership structure.

  • 2 million shares of Common Stock held by the founders
  • 1 million shares of Series A Preferred that were issued at a price of $2 and are convertible into Common Stock at a ratio of 1. Series A stockholders have a full ratchet anti-dilution provision.

Consequently, on an as-converted basis, the founders hold 66.7% of Common Stock whereas the Series A investors hold 33.3% of Common Stock.

Now the firm issues 100'000 new Shares of Series B Preferred at a price of $0.50 per share to raise a total of $50'000. How does this second round of financing affect the company's ownership structure?

 

Because the issue price of Series B is below that of Series A (down round), the full ratchet is triggered:

  • Originally, the 1 million Series A Preferred were converted at a price of $2 into common equity (1 million shares of Common Stock for a capital investment of $2 million). 
  • With the full ratchet, the conversion price is lowered to 0.5.
  • 3 million additional shares are issued to the Series A investors.
  • Consequently, Series A investors will end up holding 4 million shares of Common Stock:
     
    \( \text{New number of shares} = \text{1 million} \times \frac{2.0}{0.5} = \text{4 million} \)

 

After the Series B financing, there will therefore be a total of 6.1 million shares outstanding (on an as-converted basis):

  • Founders: 2'000'000 shares
  • Series A investors: 4'000'000 shares
  • Series B investors: 100'000 shares

The firm's capitalisation table after the Series B round will therefore look as follows:

  

  Founding   Series A Round   Series B Round
  Shares Fully diluted ownership   Shares Fully diluted ownership   Shares Fully diluted ownership
Common Stock 2'000'000 100.0%   2'000'000 66.7%   2'000'000 32.8%
Series A Preferred       1'000'000 33.3%   4'000'000 65.6%
Series B Preferred             100'000 1.6%
Fully diluted Shares 2'000'000 100.0%   3'000'000 100.0%   6'100'000 100.0%

  

The table shows what a massive impact the full ratchet can have on the firm's ownership structure. In our stylised example, the Series A Preferred investors see their fractional ownership increase by 32% from 33.3% to 65.6% due to the full ratchet. This increase in fractional ownership occurrs at the cost of the founders: Their ownership stake drops from 66.7% to 32.8%. So the founders lose their majority stake because of the anti-dilution mechanism.

As a comparison, the following table shows the firm's capitalization table if there are no anti-dilution provisions in place and the Series A investors, therefore, maintain their 1'000'000 shares:

 

  Founding   Series A Round   Series B Round
  Shares Fully diluted ownership   Shares Fully diluted ownership   Shares Fully diluted ownership
Common Stock 2'000'000 100.0%   2'000'000 66.7%   2'000'000 64.5%
Series A Preferred       1'000'000 33.3%   1'000'000 32.3%
Series B Preferred             100'000 3.2%
Fully diluted Shares 2'000'000 100.0%   3'000'000 100.0%   3'100'000 100.0%

   

One potential drawback of the full ratchet is that it does not take into consideration the amount of capital that is raised in a down round. In our example, the down round was comparatively small ($50'000 vs. $2 million for the Series A round), yet it triggered the full ratchet an thereby significantly altered the ownership structure. 

This concern is exactly what the Weighted Average Anti-Dilution Provision tries to address.