Valuations, Deal Terms, Stock Prices
of Venture Capital Financings
There are two principal ways to formulate antidilution provisions, capitalizing the terms to make it clear we are talking about the ones which have substantive bite- the "Full Ratchet" and the "Weighted Average." Full Ratchet provisions are the real killers, at least from the founder's point of view. They provide that, if one share of stock is issued at a lower price, or one right to purchase stock is issued at a lower aggregate price (exercise price plus what is paid, if anything, for the right), then the conversion price of the existing preferred shares  is automatically decreased, that is, it "ratchets down," to the lower price.  Depending on how many shares (or rights) are included in the subsequent issue, this can be strong medicine. A brief example will illustrate. Assume Newco, Inc. has one million common shares and one million convertible preferred shares outstanding; the founder owns all the common, and the investors own all the preferred, convertible into common at $1 per share. Newco then issues 50,000 shares of common at .50¢ per share because it desperately needs $25,000 in cash. To make the example as severe as possible, let us say the investors control the board and they make the decision to price the new round of financing at .50¢. Suddenly the preferred's conversion price is .50¢, the founder goes from 50 percent of the equity to under 33.3 percent, and all the company has gained in the bargain is $25,000. Indeed, a Full Ratchet would drop the founder from 50 percent of the equity to 33.3 percent if the company issued only one share at .50¢. This is a harsh result, indeed. When a really dilutive financing occurs, say shares have to be sold at .10¢ per share, the founder drops essentially out of sight. The company takes in $5,000 and the founder goes down under 10 percent, never to recover because he does not have the cash to protect himself in subsequent rounds. In the jargon of venture capital, he has been "burned out" of the opportunity. There is no other provision so capable of changing the initial bargain between the parties with the dramatic effect of Full Ratchet anti-dilution. When venture capitalists are referred to as "vulture capitalists," it is likely the wounded founders are talking about dilutive financings and a Full Ratchet provision.
The more moderate position on this issue has to do with Weighted Average antidilution provisions. There are various ways of expressing the formula but it comes down to the same central idea: The investors' conversion price is reduced to a lower number but one which takes into account how many shares (or rights) are issued in the dilutive financing. If only a share or two is issued then the conversion price does not move much; if many shares are issued-that is, there is in fact, real dilution-then the price moves accordingly.
The object is to diminish the old conversion price to a number between itself and the price per share in the dilutive financing, taking into account how many new shares are issued. Thus, the starting point is the total number of common shares outstanding prior to the dilutive financing. The procedure to achieve the objective is to multiply the old conversion price per share by some fraction, less than one, to arrive at a new conversion price; the latter being smaller than the former, the investors will get more shares on conversion and dilute the common shareholders (the founder) accordingly. The fraction is actually a combination of two relationships used to "weight" the computation equitably. The first relationship is driven by the number of shares outstanding, the weighting factor, meaning that the calculation should take into account not only the drop in price but the number of shares involved-the significance of the dilution, in other words. Call the number of shares outstanding before the transaction-A.
The fraction, then, takes into account the drop in price and expresses that drop in terms that can be mathematically manipulated with the first number to get a combined, weighted result. The relationship is between the shares which would have been issued for the total consideration paid if the old (i.e., higher) conversion price had been used versus the shares actually issued (i.e., the shares issued at the new price.) Call these two numbers-C and D.
The combination of these two relationships-number of shares outstanding and the comparative effect of the step down in price (expressed in number of shares)-is a formula:
If the shares which would have been issued at the old (i.e., higher) price is (as indicated) the number in the numerator, the fraction or percentage will be less than one. This fraction (say 1/2 or .50) is multiplied by the existing (or initial) conversion price to obtain a lower conversion price, which means in turn that more shares will be issued because the conversion price produces the correct number of shares by being divided into a fixed number, usually the liquidation preference of the preferred stock.
It is open for theorists to argue about the fairness of that result, but the above formula has the advantage of economy of expression. If one wants to use a Weighted Average antidilution formula, the above is one commonly used (albeit expressed in different terms).
The calculations get more complex, as rounds of financing multiply. If the investors in round one (holding series A preferred) enjoy a conversion price of $1, and the price for the round two (series B) investors is $1.50, and the round three (series C) preferred is convertible at $4 and there then occurs a dilutive financing at .50¢, all the conversion prices are affected, but it takes a computer to figure out who is entitled to what number of shares, particularly since investors in the various rounds will tend to overlap. (In this connection, one occasionally encounters a formula which keys off accumulated dilution. Thus, in the example cited, and depending on the amount raised in each instance, only the series C preferred holders would get an adjustment in their conversion price; the earlier investors would hold fast because the Weighted Average price of all subsequent rounds, taken together, is above their price.)
 For purposes of simplicity, it is assumed that the investors enjoying antidilution protection hold convertible preferred shares.
 A lower conversion price means a larger number of shares on conversion since the conversion price operates by being divided into a set number, usually the liquidation value of the preferred stock. Say thatliquidation preference is $10 and the old conversion price is $1. Each share of preferred converts into $10 + $1.00, or 10 shares of common. If the conversion price is .50¢, the number of common shares goes up to 20..
 Some venture capitalists argue for Full Ratchet provisions as a bargaining chip, intending to afford some relief to the founder(s) in the event of a "burnout" financing.
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
McCarter & English, LLP
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