Weighted Average Antidilution
With new rounds getting harder and harder to do and with valuations going down, certain preferred stock terms are taking on more significance than they normally do. Weighted average antidilution is one of those terms. It is so standard that very little thought is ever given to it. The effect of the antidilution provision is to disproportionately shift some of financial dilution to the common stockholders.
It is pointless to argue about the intellectual underpinnings of this practice, because the practice is universal among venture investors. Having said that, you need to understand how the weighted average antidulition formula works. You also need to understand the various flavors it comes in because some are better than others from the point of view of the common holders.
Finally, you need to understand what "full ratchet" antidilution is and how it works. This will be the subject of another post because the effect of this type of provision can be devastating to founders and I don’t want it to be lost in what is a long and turgid post on the subject of more normal antidilution provisions. Full ratchet is not commonly used, but it has its place, and it tends to become more used in difficult investment climates, such as the one we are in.
In general, weighted average antidilution has the effect of increasing the number of shares of common stock into which preferred stock can be converted if any shares of common stock or preferred stock (or other securities convertible into common stock) are sold by the company at a per share price below the conversion price of the preferred stock.
By way of example, assume, as is often the case, that a company sells Series A preferred stock at $1.00 per share and those Series A shares are convertible at a rate of $1.00 per share. If the company sells $1,000,000 of its Series A preferred stock on these terms, then it will be obligated to issue 1,000,000 shares of its common stock upon conversion of the Series A preferred stock.
If, as discussed in a prior post, the same company sells shares of its Series B preferred stock at $0.25 per share, the holders of Series A preferred stock will suffer financial dilution. To partially protect themselves from this dilution, the Series A preferred stock will have a provision (the antidilution provision) that will lower the conversion rate applicable to the Series A preferred stock from $1.00 to some lower amount. I go into the formula in gruesome detail in my article on the subject, but for the moment assume the formula results in a conversion rate of $0.50. At this new lower rate, the company will be obligated to issue 2,000,000 shares of common stock upon conversion of the Series A preferred stock. You do the math. You can see that under some scenarios this adjustment can have a very negative effect on the founder.
The formula for adjusting the conversion rate is sensitive to both the number of new shares issued as well as the price at which the new shares are issued. As a result, a small offering relative to the number of shares outstanding at a small discount to the prior transaction, will result in only a small adjustment to the conversion rate whereas a large offering relative to the number of shares outstanding at a much lower price will result in a large adjustment.
You should note that the amount of the adjustment is affected by the number of shares outstanding. Thus there will be a larger adjustment if the new offering is for a number of shares equal to 50% of the outstanding shares than if the new offering is for 10% of the outstanding shares.
This brings me to the point that I really wanted to get to: The way you count shares outstanding for the purposes of the formula can affect the amount of the adjustment.
The one real variable in counting the number of shares outstanding is whether and to what extent you include options. There are three choices (1) don’t include them, (2) include outstanding granted options, or (3) include the allocated option pool. Clearly, including the option pool results in the least dilution to the common stockholders.
If you already have a Series A outstanding, then you have already agreed to a formula. Check it and see what you have. If you are negotiating your first series of preferred stock, try to get the entire option pool treated as outstanding.
The NVCA form provides for the intermediate option, but discusses this issue generally.
The argument for treating the entire pool as outstanding is that the investors have treated it this way to determine the pre and post money valuation of the company in connection with their investment. If you then do not treat the entire pool as outstanding, you are in effect lowering the company valuation below what you agreed to.
The time to attack this issue is at the term sheet stage, since most term sheets will specify the formula to be used. By the way, most investors are completely familiar with the point and know perfectly well what they put in their term sheets. So, you don’t need to be shy about raising this issue.
