‘The VC Series’ is a series of articles aimed at founders who are thinking of raising funds from venture capital investors. Further information about The VC Series can be found here.
One of the key protections sought by venture capital funds are anti-dilution rights. This article explains what is meant by anti-dilution and explores the differences between the two types of anti-dilution calculation.
When a company issues shares to new investors, it can have the effect of reducing existing shareholders’ ownership percentages in the company. Pre-emption rights will provide the VC (and other shareholders) with an opportunity to protect themselves against this percentage dilution, by allowing them to subscribe for the number of shares necessary to maintain their percentage shareholding.
However, this will not protect a shareholder from economic dilution, which occurs when a company issues shares at a price that is lower than the price at which shares were issued in a previous funding round (i.e. where the company’s pre-money valuation in the new round is lower than the post-money valuation of the previous round). This is commonly known as a ‘down round’ and causes economic dilution as the value of an existing investor’s stake in the company will be reduced (i.e. will be worth less than at the time it invested).
To protect against economic dilution as a result of a ‘down round’, VCs often require anti-dilution provisions that will compensate them for this loss of value.
The way this works is that holders of preferred shares will, on a down round, have the right to receive additional shares at no or minimal cost, the effect of which will be to maintain the economic value of their shareholding.
This will typically be done by way of issuing the VC free shares (as a form of dividend). However, in the event that the company does not have sufficient available reserves to do this, then the VC will have the right to subscribe for shares at nominal value. This is one of the reasons that preferred shares will typically have a very low nominal value.
The number of shares to be issued to the down round investors will depend upon which anti-dilution mechanism has been agreed in the documents. The two types of protection are full ratchet and weighted average.
This is the most investor friendly mechanism and is very rarely seen in UK transactions. It has the effect of putting the investor in the position it would have been in had it subscribed for shares at the same price as the down round – so for each £1 of value lost, they will be compensated £1 in free shares, irrespective of the amount of money being raised in the down round.
This is the most dilutive mechanism for founders and other ordinary shareholders (who would not benefit from the anti-dilution protection) and should be avoided.
The weighted average mechanism takes a more balanced approach, crucially taking into account the number of shares that were issued as part of the down round (as opposed to the binary approach taken with the full ratchet mechanism). This means that a down round where £250,000 is raised will result in significantly fewer anti-dilution shares being issued than if, say, £2,500,000 is raised.
There are two types of weighted average ratchets, with the difference being how you calculate the number of shares prior to the down round. The ‘narrow-based weighted average’ takes into account only the current issued share capital, whereas the ‘broad-based weighted average’ is based on the fully diluted share capital of the company (taking into account, for example, any unexercised share options). The latter approach is less diluted to the ordinary shareholders.
Each approach has a different formula for calculating the number of additional shares that are to be issued to the preferred shareholder – this is beyond the scope of this article, but we would be happy to discuss any of these options in more detail with you.
Whilst anti-dilution protection is a common requirement of VCs (particularly where they are being asked to agree to an optimistic valuation), it is important that you are clear as to the effect it might have in a down-round scenario. If it is not done properly then it can have significant consequences to the shareholdings of founders and other ordinary shareholders.
Ultimately though, the greatest protection against anti-dilution rights is to make sure that they are never triggered – this can be done by agreeing a sensible valuation at the outset and/or avoiding a down-round at all costs…!
The next article in The VC Series explores board representation and meetings in more detail.
You can find details of all the different articles in the VC Series here.
If there is anything that we have not covered which you would find useful, then please let us know.