Emerging Enterprise Center Blog : Boston Startup Lawyer & Attorney : Foley Hoag Law Firm : Startup Financing, Venture Capital

I have been thinking of the NVCA meeting of the forms group that I attended in LA last week. One of the themes of this group has been to make the NVCA forms even handed. The forms are not intended to be either investor friendly or entrepreneur friendly. They are intended to represent a fair compromise of the issues that are inherent in any VC investment. They are also intended to be consistent with current market practices. So, if the market has evolved in a direction that seems unbalanced, well, the form reflects market practices. In the areas where practice is variable, the forms either provide alternative provisions or make reference to differences in footnotes.

One good example of how the NVCA forms try to balance fairness and current practice is in the area of founder representations. Founder representations are rare (extremely rare) in west coast deals but appear with some frequency in east coast deals. In general, the trend is away from founder reps. So, the forms (in their next iteration) will provide a footnote explaining this (and going through the limitations commonly seen in connection with founder reps, when they appear).

Having said this, to the extent that there are obvious areas of unfairness that have found their way into regular market practices, then the forms just reflect the prejudices of the market. One example of this is the ubiquitous presence of weighted average antidilution provisions. I believe that (with the exception of deals that have full ratchet provisions – far worse for entrepreneurs) all VC investments have weighted average antidilution provisions. Despite what I am about to say, don’t try to get these provisions out of VC docs; you will fail and will waste time, resources, and will leave an impression that you are difficult to deal with.

How can anyone justify antidilution? As far as I can tell the reasoning is that it is up to management to increase shareholder value. If management fails to do this, the argument goes; they should take a hit for that failure. As far as it goes, that argument has some merit.

If we agree with this argument, how do we deal with the effect of antidulition provisions on common stockholders other than management (angel investors for example). By the way, management is often holding options, and they are often "topped up" with more options. In effect, the people who suffer the ill effects of antidilution are not the people who are responsible for the performance of the company.

If you get past the issue I just described, how do you deal with declines in shareholder value that are not due to poor management? For example, what if there is a world-wide recession that affects all businesses, without regard to the quality of management? What justification is there to put greater risk of macro-economic events on management (or the common holders) than on investors?

Let me be clear, if you try to get antidilution provisions out of VC investment docs, you will (a) fail and (b) cause people to think that you are weird. So don’t try.

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I have been out of the country and not watching the blog scene as carefully as I should, but as I sit here in Beijing waiting for my delayed flight, a friend has brought two postings to my attention, and they are both good posts.

Data on the startup/venture industry:

Techcrunch has posted its exec summary (or a portion thereof) for its first year in review.  In an industry where good data (let alone information) is hard to come by, this promises to be a welcome new source.  Congratulations. 

With respect to antidilution:

Fred Wilson has a post on "Founder Dilution -- How Much is Normal."  It is followed by something like 62+ comments almost all of which are worth the read if dilution concerns you.  There are also a number of links that may also be of interest. 

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In the rogue’s gallery of investor protective provisions that come out of their cave in bad times, the multiple X preference is among the first. A preference is a provision that gives an investor a return in the event of a sale of the business before any money goes to the common stockholders. So, in a typical (and very commonly seen in good times as well as bad) 1X participating preferred, the investors get a payment in an amount equal to their investment plus accrued and unpaid dividends before the common get anything. After receiving this payment, the investors participate with the common on an as converted basis. My article on antidiluton, has a detailed description of the effect of this provision. However, just imagine the effect on the common stockholders of a 3X or, God forbid, a 5X preference. After the dotcom bust, these things appeared like mushrooms after rain. Try to resist these things. Having said that, it may be the only way to get financed, so be realistic. It may be possible to negotiate capped preferences in which the investor gets his or her preference but only up to some limit. In any event, do the math at various exit values. It could turn out that a multiple X preference makes working for someone else rather than starting a venture financed business look good. 

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Bad times may well cause this beast to come out of its cave. Full ratchet antidilution is a provision that protects investors to the max from low priced issuances. The gist of this provision is that the conversion price of a security (usually preferred stock, but not necessarily) will be reduced to the lowest price at which a company sells any shares of its common stock. So, if you have 1,000,000 shares of preferred outstanding with a conversion rate of $1.00, these shares will convert into 1,000,000 shares of common stock. However, if these shares have a full ratchet antidiluton provision and you issue one share of common stock for $.10, then the conversion rate will drop to $.10, and the preferred stock will convert into 10,000,000 shares. You can imagine the dilutive effect on other stockholders. 

For the reason outlined above, full ratchet is rarely used. However, it does have its place when there is a disagreement about valuation. If you can’t bridge the valuation gap, you might end up saying something like “OK, if I have to raise money next year at a lower valuation than you are getting, I will adjust you to that valuation.” In a world where money is very hard to come by and investors are very nervous about valuation, I predict we will start seeing more of these provisions.

Having said that, if you are constrained to agree to full ratchet, you need to consider negotiating some parameters around it. By way of example, try to exclude options issued under the option plan, try to exclude small issuances of warrants to equipment lessors, try to limit the time period in which the full ratchet operates to some period (perhaps one year). Consider other issuances that you might make and try to negotiate exceptions for them. Also, consider a range inside of which you don’t have to make the adjustment. For example, consider trying to negotiate a provision the gist of which is that the full ratchet will only operate if you raise more than $X at a valuation that is less than 90% of the preferred.

Full ratchets have another negative effect, they cause the next investor to want one too. Consider negotiating a termination upon closing of the next round.

I predict that the next year will see an increase in full ratchet provisions.

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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.

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Antidilution has been the topic of a prior post and is kind of a tough topic.  I find I have to go over the concepts carefully with entrepreneurs. Some entrepreneurs tend to think of dilution as purely a matter of percentage ownership. Although ownership dilution is important particularly as it relates to voting control, investors are typically more concerned with financial dilution. Financial and ownership dilution are related but different concepts. Ownership dilution is easy to explain, if Easy Company has 1,000,000 shares issued and outstanding in the hands of stockholders, and you own 500,000 of these, you own 50% of Easy Company. If Easy Company then sells another 1,000,000 shares to a new investor, there will be 2,000,000 shares outstanding and you will still own 500,000, but now you only own 25% of the company. That is ownership dilution. 

Financial dilution is a little more complicated to explain. Using the same example, if Easy Company had 1,000,000 shares outstanding and sold 500,000 to you for $1.00, you would own half of the company and your shares would be worth $1.00 each or $500,000.  If time passes and Easy Company raises an additional $1,000,000 at $2.00 per share it would issue 500,000 new shares to new investors. As a result, there would be 1,500,000 shares outstanding of which you would own 500,000 or one third. So, you would have ownership dilution (you went from one half to one third). However, the company would have a valuation of $3,000,000 ($2.00 multiplied by the number of shares outstanding after the new financing). The value of your shares would have increased – not been diluted.

Suppose, however, that Easy Company raised $1,000,000 by selling shares at $.50 per share. It would then issue 2,000,000 new shares to new investors and the total number of outstanding shares would go from 1,000,000 to 3,000,000. The value of the company would be $1,500,000, and the value of each share would be $.50. In this example, your 500,000 shares now represents approximately 16.67% of the company (down from 50%) so you have suffered ownership dilution, and your shares are now worth $.50 each (down from $1.00) so you have suffered financial dilution.

The antidilution formulas that are a customary part of venture investments, are aimed at protecting the investor from financial dilution. How the typical formula works will be the topic of another blog entry, but for a very detailed analysis, see my article on the subject of antidilution.

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In a recent board meeting for a client, one VC director described the current investment climate as follows:  "flat is the new up 50%."  Assuming he is right, and I think he probably is, several things follow.  Some of them are obvious.  Valuations are down; it is harder to get money than it was just a few months ago etc.

However, here is another prediction (perhaps it is obvious as well).  Certain deal terms that we have not seen since 2001 will start cropping up like mushrooms after rain.  Look out for full-ratchet antidilution provisions and multiple X preferences.  Also, you may want to review a section of your preferred stock that you may not have paid much attention to -- your antidilution provisions -- because they will be triggered by a down round.

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