Reading: Protection and Participation

As an additional practice exercise, consider a firm that has conducted two rounds of external financing in the past (Series A and Series B) and is now facing the third round of financing, namely Series C. The following table summarizes the relevant information about the three financing rounds:

As the table shows, round C did not go very well and the firm had to lower the issue price to $2 per share (compared to $5 per share in round B). With this information, let us now try to determine the ultimate ownership structure of the company (fully diluted) under the following three scenarios:

• The Series A and B investors have no dilution protection against down rounds
• The Series A and B investors have full ratchet anti-dilution provision against down rounds
• The Series A and B investors have weighted average anti-dilution provision against down rounds.

Scenario 1: No Dilution Protection

Under this scenario, the ultimate ownership structure (fully diluted) will correspond to the ownership structure summarized in the preceding table. There will be a total of 22.2 million shares outstanding:

• Founders: 10 million shares
• Series A investors: 7 million shares
• Series B investors: 2.7 million shares
• Series C investors: 2.5 million shares.

Consequently, the firm's capitalization table before and after round C will be:

Common Stock, Series A, and Series B are diluted pro-rata by the appearance of the new Series C investors. 

Scenario 2: Full Ratchet Anti-Dilution Provision

Round C is a down round from the point of view of the Series B investors, as they have purchased their shares at $5 whereas the new Series C investors can purchase shares at $2. Round C therefore triggers the full ratchet for the Series B investors: Their conversion price is reduced from $5 to $2. Given an investment of $13.5 million, the full ratchet implies that their number of common shares increases from 2.7 million to 6.75 million. 

For all other investors, Round C is not a down round. Therefore, for them, no ratchets are triggered. 

With the full ratchet, the firm's capitalization table before and after round C will therefore be:

Because of the anti-dilution provision, the fractional ownership of the Series B investors increases from 13.7% (before Round C) to 25.7%. As we have seen in the previous table, absent anti-dilution provision, these investors would only own 12.2% of the fully diluted common stock after Round C. The anti-dilution provision of the Series B investors substantially increases the extent to which the other investors (founders and Series A investors) are diluted. 

Scenario 3: Weighted Average Anti-Dilution Provision

Finally, under the weighted average ratchet, the conversion price of Series B will be adjusted as follows:

• Old conversion price: $5.00
• A: Number of shares immediately before Round C: 19.7 million (10 million Common, 7 million Series A Preferred, 2.7 million Series B Preferred). 
• B: Number of shares issued in Round C if it were conducted at the same price as Series B: 1 million [$5 million total investment at a price of $5.00].
• C: Actual number of shares issued in Round C: 2.5 million.

Consequently, the new conversion price for Series B shareholders will be lowered to $4.6622:

\( \text{New conversion price} = \text{Old conversion price} \times \frac{A+B}{A+C} = 5 \times \frac{19.7+1.0}{19.7+2.5} = 4.6622 \)

Instead of 2.7 million shares, the Series B investors will therefore own 2'895'652 shares after round C (=$13.5 million divided by $4.6622). With the weighted average ratchet, the firm's capitalization table before and after round C will therefore be: