What all this “Dilution Stuff” about?
The team at eleva8or has been helping startups negotiate terms for their early stage investments. One critical area which seems to emerge consistently in emerging markets is the question of dilution. It is important for start-up entrepreneurs to understand dilution and very important component which mitigates dilution called “ratchet”. Lets get in to the discussion by first defining dilution and then following up with some examples and explaining the meaning of the ratchet provisions.
Dilution refers to the phenomenon of a shareholder’s ownership percentage in a company decreasing because of an increase in the number of outstanding shares, leaving the shareholder with a smaller piece of the corporate pie. The total number of outstanding shares can increase for any number of reasons, such as the issuance of new shares to raise equity capital or the exercise of stock options or warrants.
However, not all dilutive issuances are harmful to the existing shareholders. If the company issues shares but receives sufficient cash in exchange for the shares, the shareholders’ ownership percentages may be reduced but the value of the company has increased enough to offset the lower ownership percentage. On the other hand, if the cash received is insufficient, the increase in the value of the company will not be enough to offset the reduction in ownership percentages.
In venture capital deals, the transaction documents typically include negotiated provisions designed to deal with a dilutive issuance that would otherwise reduce the value of the preferred investors’ shares (relative to the price the preferred investors paid for their shares). These provisions are referred to as “anti-dilution provisions.”
In venture capital terms, dilution becomes a concern for preferred stockholders when confronted with a “down round” — a later issuance of stock at a price that is lower than the preferred issue price. Anti-dilution provisions protect against a down round by adjusting the price at which the preferred stock converts into common stock.
There are three common alternatives for anti-dilution provisions full ratchet, weighted average, and no price-based anti-dilution protection.
A “full ratchet” provision is the simplest type of anti-dilution provision but it is the most burdensome on the common stockholders and it can have significant negative effects on later stock issuances. Full ratchet works by simply reducing the conversion price of the existing preferred to the price at which new shares are issued in a later round. So if the preferred investor bought in at $1.00 per share and a down round later occurs in which stock is issued at $0.50 per share, the preferred investor’s conversion price will convert to $0.50 per share. This means each preferred share now converts into 2 common shares.
Full ratchet is easy and it’s the most advantageous way to handle dilution from the preferred investor’s standpoint but it is the most risky for the holders of any common stock. With this approach, the common stockholders bear all of the downside risk while both common and preferred share in the upside.
Full ratchet can also make later rounds more difficult. If the company needs to issue a Series B round and the stock price has decreased, it may be difficult to get the Series A investors to participate because they are getting a full conversion price adjustment. In essence, the Series A investors are getting more shares without putting more cash in the Series B round. In addition, the full ratchet provision will reduce the amount the Series B investors will be willing to pay in a down round (simply because full ratchet results in more shares outstanding on an “as converted” basis).
A second and more gentle method for handling dilution is referred to as the “weighted average” method.  Following is the calculation for a typical weighted average anti-dilution provision:
CP2 = CP1 * (A+B) / (A+C)
CP2 = Conversion price immediately after new issue
CP1 = Conversion price immediately before new issue
A = Number of shares of common stock deemed outstanding immediately before new issue 
B = Total consideration received by company with respect to new issue divided by CP1
C = Number of new shares of stock issued
Let’s suppose a company has 1,000,000 common shares outstanding and then issues 1,000,000 shares of preferred stock in a Series A offering at a purchase price of $1.00 per share. The Series A stock is initially convertible into common stock at a 1:1 ratio for a conversion price of $1.00.
Next, the company conducts a Series B offering for an additional 1,000,000 new shares of stock at $0.50 per share. The new conversion price for the Series A shares will be calculated as follows:
CP2 = $1.00 x (2,000,000 + $500,000) / (2,000,000 + 1,000,000) = $0.8333.
This means that each of the Series A investor’s Series A shares now converts into 1.2 shares of common (Series A original issue price/conversion ratio = $1.0 /$0.8333 = 1.2).
Under the discussion of full ratchet above, we noted that the preferred shares became convertible into 2 common shares post-issuance. Under weighted average, the preferred shares became convertible into 1.2 shares. This simple example illustrates that the weighted average approach is much less beneficial for the preferred investor but much less onerous for the common stockholders.
However, to provide a little more context, let’s assume our hypothetical company is sold and liquidated for $10,000,000 after the Series B round. We’ll also assume, for simplicity, that there was no dividend preference for the preferred shares and that we’re using a non-participating structure. Here’s how the cash gets distributed with full ratchet and weighted average, respectively:
Note how much more the Series A investors get with full ratchet and how much this reduces the amounts distributable to Series B investors and common stockholders.
No Price-Based Anti-dilution Protection
The third alternative for anti-dilution is the no price-based anti-dilution protection. In this scenario, the preferred investor bears the risk of a down round along with the common stockholders. This is the fairest from the standpoint of the common stockholders but many preferred investors will not agree to take the down round risk without any anti-dilution protection
 The entire discussion on the topic of dilution is sourced from third party material and analysis done by eleva8tor team when speaking with various startups as part of the advice provided by eleva8tor to start up entrepreneurs