Down Rounds Decoded: Understanding Anti-Dilution Protections

In more challenged private company financing environments, down rounds (i.e., an equity financing at a lower valuation than a prior equity financing) often go from a relatively uncommon occurrence to a more common aspect of many growth equity and venture capital financings. The interrelated impact of geopolitical and macroeconomic events such as valuation resets from post-pandemic highs, public and private market liquidity constraints, prolonged fundraising cycles, and shifts in bargaining power can have profound effects on growth equity and venture capital financing dynamics, making down rounds and valuation pressure more common. Down rounds have significant implications for all participants in the venture ecosystem: founders and management teams, investors, employees, and fund limited partners.

This article focuses on the basic mechanics of conversion price-based, anti-dilution protections for convertible preferred stock. Anti-dilution protections need to be considered in the context of the impact on the pricing of the down round in question, and also on the potential impact of future adjustments.

Anti-Dilution Protections

In any equity financing, two types of dilution can occur when a company issues new shares: (1) percentage dilution occurs because the issuance increases the number of outstanding and fully diluted shares, reducing an existing holder’s ownership percentage if that holder does not maintain their ownership percentage through additional investment, and (2) economic (or price) dilution occurs when a company issues shares at a price that is lower than the conversion price applicable to an investor’s shares, reducing the value of that investor’s position on an as-converted basis.

The conversion price-based anti-dilution protections discussed below are intended to mitigate economic (or price) dilution and the resulting percentage dilution on an as-converted basis. Investors may also help protect against percentage dilution through preemptive rights, which can permit pro rata participation in later financings, whether those are up rounds or down rounds.

Below is a simple illustration of how dilution can occur:

• Before a down round, if Investor A purchased 2,500,000 shares of convertible preferred stock at a price of $5 per share, and after that financing there were 10,000,000 shares of the company outstanding, Investor A’s $12,500,000 investment would represent a 25% ownership stake in the company.
• In the down round, the company sells 5,000,000 new shares to investors (other than Investor A) at a price of $4 per share.
• Following the down round, Investor A continues to own 2,500,000 shares of convertible preferred stock, now out of 15,000,000 outstanding shares of the company, representing a decreased ownership stake in the company of 16.67%, valued at approximately $10,000,000.

To help protect against the scenario above, Investor A would typically have negotiated for price-based anti-dilution protection when it originally purchased its convertible preferred shares. In a down round, these protections operate to adjust Investor A’s conversion price and therefore the rate at which those shares ultimately convert into common stock. There are two main types of conversion price-based anti-dilution protection: (i) full ratchet and (ii) weighted average.

Full Ratchet

While less common in practice, there has been an increased use of full-ratchet anti-dilution protections to bridge valuation gaps (sometimes, with a sunset date). When used, they can have a profound impact on down-round financing. With full ratchet anti-dilution protection, the conversion price applicable to Investor A’s convertible preferred shares is reset to the new lower price per share from the down round (which is $4 in the example above) meaning each preferred share from then on would convert into 1.25 shares of common stock.

Now, as a result, if those preferred shares convert, Investor A would own 3,125,000 shares of common stock out of 15,625,000 outstanding shares, meaning Investor A would therefore have a 20% ownership stake (which is less than Investor A’s initial 25% stake, but greater than the 16.67% stake Investor A would have been left with without this full ratchet protection).

Full ratchet protection is not common, but when it does exist, the resulting impact in a down-round financing can be profound.

Weighted Average

Weighted-average anti-dilution protection is far more customary. With weighted-average anti-dilution protection, a formula is used to determine a new conversion price that will apply to existing preferred shares following a down round:

• New Conversion Price = Old Conversion Price * [(X + Y) / (X + Z)]
  • X = the number of shares outstanding on a fully-diluted basis before the down round.
    • Note that the nuances of the X variable are sometimes negotiated, with a company preferring a broader approach (often referred to as the “broad-based” weighted-average formula) that includes all shares on a fully diluted basis, and an investor preferring a narrower approach (often referred to as the “narrow-based” weighted-average formula) that excludes certain types of derivative shares such as options and warrants. The broad-based weighted-average formula is more commonly used.
  • Y = the number of shares that would have been issued to new investors in the down round had the full investment been made at the old price per share (which is $5 in our example above).
  • Z = the number of shares issued to new investors in the down round at the new price per share ($4 in our example).

In our example, the resulting math would be:

New Conversion Price = $5.00 * [(10,000,000 + 4,000,000) / (10,000,000 + 5,000,000)]

• $5.00 * [(14,000,000) / (15,000,000)]
• $5.00 * [0.933]
• $4.67

Under this approach, the adjusted conversion price applicable to Investor A’s convertible preferred shares is now $4.67, meaning each of Investor A’s preferred shares is convertible into 1.07 shares of common stock.

Now, if those preferred shares convert, Investor A would own 2,675,000 common shares out of 15,175,000 outstanding shares, meaning Investor A would therefore have a 17.63% ownership stake (which is less than Investor A’s initial 25% stake, and less than the 20% stake Investor A would have had with full-ratchet protection, but more than the 16.67% stake that would have resulted without any protection).

Economic Dilution

As mentioned above, conversion price-based anti-dilution protections are designed to reduce the impact of percentage dilution, but they also mitigate economic dilution. Continuing with our example:

• Before the down round, the value of Investor A’s as-converted stake in the company was $12,500,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • $5.00 * 2,500,000)
    • $12,500,000

• Without any anti-dilution protection, the value of Investor A’s as-converted stake in the company would drop to $10,000,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • ($4.00 * 2,500,000)
    • $10,000,000

• With full-ratchet anti-dilution protection, the value of Investor A’s as-converted stake in the company would remain $12,500,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • ($4.00 * 3,125,000)
    • $12,500,000

• With weighted-average anti-dilution protection, the value of Investor A’s as-converted stake in the company would drop to $10,700,000 instead of $10,000,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • ($4.00 * 2,675,000)
    • $10,700,000

Down Round Pricing Must be Modeled Holistically

These anti-dilution mechanics may be familiar to and understood by most management teams, investors, and advisors, but the practical implications are often not as straightforward. In practice, the negotiated enterprise value, or pre-money valuation, of a company is typically set at the outset of a negotiation, but the resulting per-share price often is not. The per-share price must generally be solved for after giving effect to anti-dilution adjustments, any option pool increase, and the resulting post-closing capitalization. When solving for this price per share, if anti-dilution adjustments would be triggered, the result is that the end-result number of as-converted shares outstanding will be higher than otherwise, which can prompt an iterative calculation. The end-result number of as-converted shares outstanding, and therefore the preferred price per share, must be solved for again.

Existing investors’ anti-dilution protections typically create a direct economic tension with the investors proposing to lead the down-round financing. This is because new investors typically bargain for a specified ownership percentage and expect their investment to buy it. Existing investors may seek to maximize the value of their anti-dilution adjustments. Common stockholders and other unprotected holders, including management and employee option holders, end up bearing much of the resulting dilution and often are most heavily “crammed down.” On the other hand, existing and new investors typically want to ensure that the management team is protected and appropriately motivated, so the option pool increases, the number of end-result fully diluted shares outstanding again changes, and the entire iterative calculation dance begins again. Add in the fact that many down rounds are led by some subset of existing investors, and the tension around the per-share price calculations increases further.

Because of these dynamics, down-round pricing should not be modeled by simply picking a per-share price. Instead, the agreed pre-money valuation, anti-dilution adjustments, option pool increase, and post-closing ownership targets should be modeled together and holistically to ensure that the intended transaction is delivered.

Discussions over a down-round transaction often expand well beyond pricing mechanics and can raise questions about participation, including the potential emergence of a pay-to-play dynamic, board fiduciary duties, voting power, minority equityholder protections, contingency planning for future financing, potential waivers of anti-dilution protections, control-investor risks, the consent process, and the consensus-building required to secure key approvals.