Reading: Protection and Participation

The Weighted Average Anti-Dilution Provision takes into account the amount of financing in the down round when adjusting the original conversion price. Formally, the typical weighted average ratchet computes the new conversion price as follows:

\( \text{New conversion price} = \text{Old conversion price} \times \frac{A+B}{A+C} \)

With:

• • A = Number of shares of Common Stock outstanding immediately prior to new issue (includes all shares of outstanding common stock, all shares of outstanding preferred stock on an as-converted basis, and all outstanding options on an as-exercised basis)
  • B = Aggregate consideration received in the down round, divided by the original conversion price. Consequently, B indicates how many new shares of stock would be issued if the financing round took place at the same price as the original round.
  • C = Actual number of shares of stock issued in the down round.

Let us apply this ratchet to our previous example. Remember that the firm had the following ownership structure immediately prior to the new issue:

• Founders: 2 million shares of Common Stock
• Series A: 1 million shares of Series A Preferred that were issued at a price of $2 per share

Also remember that the firm then issued 100'000 shares of Series B Preferred at a price of $0.5 each, for a total financing of $50'000.

With this information, we can compute the relevant parameters for the weighted average ratchet:

• Old conversion price: $2. This is the applicable conversion price of Series A right before the Series B issue.
• A: Immediately prior to the Series B issue, there are 3 million shares outstanding (on a fully diluted basis)
• B: If the Series B issue were priced like the Series A issue ($2 per share), the firm would have to issue 25'000 new shares [total proceeds of 50'000, divided by the original issue price of $2].
• C: With the new round, the firm actually issues 100'000 new shares of Series B Preferred.

Based on this information, the new conversion price for Series A shares is $1.9516:

\( \text{New conversion price} = \text{Old conversion price} \times \frac{A+B}{A+C} = 2 \times \frac{3'000'000 + 25'000}{3'000'000+100'000} = 1.9516\)

With an original investment of $2 million, the Series A Preferred investors will therefore receive 1.025 million shares of Common Stock after conversion:

Adjusted number of Series A = \( \frac{\text{Original investment}}{\text{New conversion price}} = \frac{2'000'000}{1.9516} = 1'024'793 \).

Consequently, there will be a total of 3'124'793 shares outstanding after the Series B round:

• Founders: 2'000'000
• Series A investors: 1'024'793
• Series B investors: 100'000

With the weighted average ratchet, the firm will therefore have the following capitalization table after the Series B round:

Because the Series B round is comparatively small, the weighted average ratchet only leads to a comparatively small adjustment of the ownership structure. While the Series A shareholders have received an additional 2 million new shares with the full ratchet (see before), the weighted average ratchet only grants them approximately 25'000 new shares. 

As a consequence, the ownership stake of the founders is substantially less diluted: With the full ratchet, the Series B round would dilute the founders down to 32.8%. Under the weighted average ratchet, the owners will still own 64.0% after the Series B round.

It is not surprising, that entrepreneurs will generally argue for the weighted average ratchet, as it is less sensitive to the size of the financing round (and the new conversion price).

In practice, one sometimes also sees a combination of the two clauses. For example, the term sheet could stipulate the following for Series A investors:

• Weighted average anti-dilution rights apply if future shares are issued at a price less than 100% and greater than 50% of the original purchase price of Series A.
• Full ratchet anti-dilution rights apply if future shares are issued at a price less than 50% of the original purchase price of Series A.

In our example above, the full ratchet would have been triggered, as the issue price of the Series B ($0.5) was only 25% of the original issue price of Series A ($2.0).