Term Sheet (9) Anti-dilution clause

Investors are often concerned that the next round of financing may be a Down Round, where the issue price of the shares is lower than their current conversion price, resulting in a devaluation of their shares, and an anti-dilution clause can protect them accordingly.

A common example of an anti-dilution provision in a Term Sheet is as follows.

Anti-dilution Provisions, The conversion price of the Series A Preferred will be subject to a broad-based weighted average adjustment to reduce dilution in the event that the Company issues additional equity securities at a purchase price less than the applicable conversion price.

Broad weighted average is mentioned here. This is because there are several different types of anti-dilution provisions, full ratchet and weighted average (where weighted average is also divided into broad and narrow weighted average).

1. Full-ratchet anti-dilution protection

Full-ratchet anti-dilution protection means that if the company's subsequent share issuance price is lower than the conversion price applicable to Series A investors at that time, then the actual conversion price for Series A investors must also be reduced to the Series B issuance price. This approach takes into account only the price at which the shares were issued at the lower price, not the number of shares issued. This means that in the case where the next round of Series B financing comes in at a lower price after the Series A financing, all Series A preferred share prices would have to follow the Series B price - even if there is only one share in the Series B financing - if the full ratchet clause is used.

Yang Kang's WanYan AI got the investment from Quanzhen Capital in the A round, and when Mei Chaofeng's B round personal investors came in, it was obviously down round, so the anti-dilution clause could be used. In other words, WanYan AI's Series A financing took $20 million from All True Capital and issued 20 million Series A preferred shares at $1 per share. As the development of WanYan AI is not as good as expected, when WanYan AI got the Series B financing from Mei Chaofeng, the issue price of Series B preferred shares fell to $0.5 per share, if the conversion price of Series A preferred shares will also be adjusted to $0.5 according to the provisions of the full ratchet clause, then the 20 million preferred shares of Series A All True Capital can be converted into 40 million common shares, instead of the original 20 million shares.

The full ratchet provision is the most favorable anti-dilution protection for preferred stock investors, but the provision has a significant dilutive impact on the shares of common stockholders. In order to make this approach less severe, it is more common to give a weighting based on the number of shares issued, and that is the weighted average approach that we will describe below.

2. Weighted average anti-dilution protection

Under the weighted average provision, if the Series B issue price is lower than the Series A conversion price, then the Series A conversion price is reduced to the weighted average of the Series A and B prices, which means that the Series A preferred shares are repriced taking into account not only the Series B issue price but also the number of Series B shares issued.

This conversion price adjustment is relatively fair, and the formula for the weighted average anti-dilution provision in the Term Sheet is as follows.

NCP=CP*(OS+SNS) /(OS+NS)=(CP*OS+IC) /(OS+NS) where

NCP - the new conversion price of Series A Preferred Stock after adjustment;

CP - the actual conversion price of Series A Preferred Stock before the subsequent financing;

OS - the number of shares at full dilution before the subsequent financing or the number of shares after the conversion of the issued preferred shares.

NS - the actual number of shares issued in the subsequent financing;

SNS - the number of shares that should be purchased with the subsequent financing (assuming that the shares are issued at the actual conversion price at that time);

IC one-one the amount of cash from the subsequent touchdown (excluding the funds received from the execution of subsequent warrants and options).

This is where we can understand it this way: the anti-dilution clause is equivalent to a value lock-in clause, so that the value of the company cannot be reduced later. Therefore when the valuation of the next round is reduced, the valuation before the subsequent financing should still be used for the original Series A investors, i.e. the valuation that would have been done if the next round was a parity financing. In the case of valuation lock-in, the conversion price after the Series A investors' financing can be calculated in steps like this.

1) Valuation = CP*(OS+SNS) = CP*OS+IC

2) Actual number of shares after financing = OS+NS

3) Conversion price after financing = valuation / actual number of shares after financing

The formula in this place is very complicated, so you can take a screenshot and save it, and then study it again and again.

The weighted average clause has two subdivided forms.

1. broad-based weighted average (BWA)

2. narrow-based weighted average

The difference between the two is the definition of outstanding shares in the later round, i.e., the OS and its number in the formula above.

(1) Broad-based weighted average is defined as fully diluted, i.e., including the number of common shares outstanding, common shares convertible into preferred shares, and common shares available through exercise options, warrants, marketable securities, etc., calculated as if all common shares outstanding prior to the Subsequent Financing (when fully diluted) were issued at the then-current conversion price;

(2) Narrowly weighted average only counts the number of common shares that can be converted from the issued convertible preferred stock, not common shares and other convertible securities.

The number calculated by the narrowly weighted average will be smaller and the number calculated by the broadly weighted average will be larger, which means that of the fully ratchet, narrowly weighted average and broadly weighted average, the fully ratchet is the most favorable to investors and the broadly weighted average is the most favorable to founders. So founders and investors tend to choose the narrowly weighted average because it is a calculation between the full ratchet and the generalized weighted average.

If the common stock of Yang Kang, the founder of Complete AI, is 80 million shares, the Series A financing of All True Capital is still 20 million shares at $1 per share, and the Series B investment of Mei Chaofeng is $30 million, and 60 million Series B preferred shares at $0.50.

(1) The new conversion price when the broad weighted average is: NCP= [ 1 * (80000000+ 20000000) + 30000000]/[(80000000+ 20000000) + 60000000] = $0.8125

(2) The new conversion price when narrowly weighted average is: NCP= [ (1 * 20000000) + 30000000] / (20000000 + 60000000) = $0.625

The $20 million invested by Series A investor All True Capital can be converted into 24.6 million and 32 million shares respectively, which is fairer compared to the previous 40 million shares.