Editor's Note:-This article gives a detailed and thorough explanation of anti-dilution protection for Employee Stock Ownership Plans (ESOPs). It explores the various forms of protection from dilution, such as weighted average, full ratchet, and contractual protection. Moreover, it also delves into essential factors to consider during negotiations related to protection from dilution for ESOPs.
Anti-dilution protection is how investors protect themselves in a down round.
ESOPs can be offered without dilution by utilizing secondary shares or cash-based options, thus preserving the current ownership proportions. On the other hand, ESOPs' anti-dilution provisions safeguard investor interests by readjusting the conversion price of their shares, if new shares are offered at a cheaper price, thereby stopping any decrease in their ownership share.
It’s obvious that just going through the above information isn’t enough to learn about this terminology. Therefore, let's grasp the concept of Anti-Dilution Protection in detail to understand it with clarity.
An anti-dilution clause is set off when the conversion price for a subsequent funding round is lower than the conversion price of the preceding round, which is usually the same as the price per share (PPS) of the preferred stock issued in that round. This provision typically increases the number of common shares each preferred share converts into during a new capital raise.
The main thing about this is that investors have two ways to leave the stock outcome: They can convert their favorite stocks into shares and get a percentage of the income, or they can buy the favorite to get preference earlier of shareholders. Of course, investors will always choose higher dividends. Additionally, hedging allows investors to maintain their percentage of ownership, allowing them to receive more distributions than they transfer into the business.
Now, let’s understand how the different types of anti-dilution protections work in detail
Price-based anti-dilution provision is included in the company's charter, which automatically changes the conversion rate of preferred stock to common stock during a down round. At first, preferred stock converts to common stock at a 1:1 ratio, affecting voting rights, the distribution of proceeds in a company sale, and the number of shares held by investors after an IPO. Once a price-based anti-dilution adjustment takes place, the conversion ratio rises to more than 1:1, causing a modification in the common stock equivalent number in the company's capitalization table .
There are two types of Price-Based Anti-Dilution: Weighted-Average Anti-Dilution and Full Ratchet Anti-Dilution
Weighted average: To offset the decrease in share value resulting from a new funding round at a lower price, this protection mechanism adjusts the conversion ratio. This readjustment is calculated using a formula that compares the number of shares that would have been given to new investors at the initial price to the number of shares issued to them at the discounted price.
For weighted average protection, the conversion price is not automatically lowered to the lowest share price. Instead, it’s modified based on the increase in the number of shares the company issued.
There are two ways to calculate weighted average anti-dilution: broad-based and narrow-based. The formulas are identical, aside from the number used for outstanding shares.
Typically, investors and founders will come to an agreement on a broad-based weighted average dilution protection. This type of protection is seen as more fair and balanced because it does not solely place the burden of dilution on shareholders who do not have these protections. It takes into account several factors, including the original investment's valuation, the amount to be raised in a down-round, and the proposed number of shares to be issued.
The Adjusted Conversion Price is determined on the basis of the following Anti-dilution formula:
Adjusted Conversion Price = CP x (A + B) / (A + C), where:
Adjusted Conversion Price
= 100 x (1,00,000 + 10,000) / (1,00,000 + 20,000) = INR 91.67.
Variable | What it represents | In our example (in INR) |
CP | Existing conversion price | 100 |
A | Total number of existing shares on a fully diluted basis prior to the down-round | 1,00,000 |
B | Number of shares issuable for the amount raised in the down round at the CP | ((20,000 x 50) / 100) = 10,000 |
C | Number of shares issuable in the down round | 20,000 |
Accordingly, applying for a broad-based weighted average protection, the Investor's ownership in the Company (on a fully diluted basis) would be 43,635 shares (40,000 *100 / 91.67) and the share capital table would be as follows:
Shareholder | Number of Shares (on a fully diluted basis) | Shareholding percentage |
Founder 1 | 25,000 | 20.22% |
Founder 2 | 25,000 | 20.22% |
Investor | 43,635 | 35.29% |
New Investor | 20,000 | 16.18% |
ESOP (unissued notional pool) | 10,000 | 8.09% |
Total | 1,23,635 | 100% |
A narrow-based weighted average protection is nearly identical to the previously mentioned broad-based weighted average protection, utilizing the same formula. The distinction is that when determining the outstanding shares (referred to as variable 'A' in the aforementioned formula), a more restricted method is implemented. This includes only the existing and issued shares while excluding unissued stock options, warrants, shares issued upon conversion/exercise of debt, and other comparable instruments.
Therefore, in the above example, Variable A will be equal to 90,000, excluding the unissued notional ESOP pool of 10,000.
Adjusted Conversion Price
= 100 x (90,000 + 10,000) / (90,000 + 20,000) =
INR 90.91
Accordingly, applying for a narrow-based weighted average protection, the Investor's ownership in the Company (on a fully diluted basis) would be 44,000 shares (40,000 *100 / 90.91) and the share capital table would be as follows:
Shareholder | Number of Shares (on a fully diluted basis) | Shareholding percentage |
Founder 1 | 25,000 | 20.16% |
Founder 2 | 25,000 | 20.16% |
Investor | 44,000 | 35.48% |
New Investor | 20,000 | 16.13% |
ESOP (unissued notional pool) | 10,000 | 8.07% |
Total | 1,24,000 | 100% |
Full Ratchet: The full ratchet anti-dilution method reduces the purchase price of protected stocks to the same level as the price paid in the subsequent financing round that had a lower valuation. Compared to a weighted average provision, a full ratchet provision will always result in a more substantial adjustment to the conversion rate, which is disadvantageous to founders and other common stockholders. Here, the new conversion price adjusts to the lowest conversion price implied by any financing round. The formula is:
Number of common shares = (Number of preferred shares) x (Original share price/Conversion Price)
Let’s look at an example based on the aforementioned sample company.
Source:learn.angellist
If there was a non-dilution protection, converting your 3M preferred shares to common shares would be at the original price of $1.00 per share, resulting in 3M common shares, each currently worth $0.83, reducing your ownership stake to 12.5% from the initial 25% ownership of the company.
However, with full-ratchet protection, you have the option to convert your 3M preferred shares to common shares at the new lower price of $0.83 per share, similar to what Series B investors paid. This would give you around 3.6M shares, each valued at $0.83, maintaining the original worth of your investment while still facing the consequences of dilution in terms of ownership percentage.
A standard form of protection sees the company commit, through a contract, to grant extra shares to a specific shareholder to ensure that the latter's percentage of ownership in the company remains constant until the company secures a certain amount of financing. This arrangement dilutes the proposed shareholder's percentage of interest in the company, irrespective of the share price.
However, if the protection does not end automatically once the subsequent round of financing is raised, new venture capital or angel investors may insist that the company obtains the agreement of the holder of such rights to terminate them before they agree to invest.
1. Preferred shareholders' increased shareholding results in decreased ownership for common stockholders, such as founders and employees. In other words, stronger investor dilution protection leads to greater potential dilution for founders.
2. Founders often oppose these protection clauses and advocate for broad-based weighted averages, with the final decision being influenced by each party's negotiating power.
3. Anti-dilution provisions are negotiable and vary based on different parties' perspectives in each financing round.
4. Full-ratchet anti-dilution provisions are uncommon as they can deter future investors and undermine founders' ownership stakes.
5. Disputes among investors can arise when prior investors' dilution protections are negotiated away, potentially delaying or preventing future financing rounds.
6. Investors may agree to fewer protections in order to maintain the company's ability to raise funds or prevent dilution for founders and employees.
7. Customizable protection provisions include 'pay-to-play' terms, negotiated by some founders, requiring investor participation in future financing rounds for protection.
8. Anti-dilution provisions are typically absent in convertible notes or SAFEs, as the valuation cap or discount rate serves as protection upon conversion to preferred shares.
Investors should not neglect anti-dilution protection when negotiating financing terms, as it is a significant factor. Generally, a weighted average anti-dilution method is the fairest solution, providing protection for investors while limiting dilution for founders and common stockholders. However, the final terms will depend on the negotiating power of each party. Giving up anti-dilution rights in future negotiations can lead to conflicts, so all stakeholders should thoroughly consider the potential implications before agreeing to any anti-dilution clauses.
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