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Conversion and Anti-dilution Provisions

Anti-dilution provisions are potentially the most threatening to founders of all the aspects of convertible preferred shares. The ratio that is used to calculate the common shares issuable upon conversion is variable, with potentially severe adverse effects on the founders and other common shareholders. Anti-dilution provisions are of two types and accomplish two basic objectives, one entirely noncontroversial and the other potentially highly controversial. The noncontroversial anti-dilution clauses are those that automatically adjust the conversion price in the event of share splits, share dividends, recapitalizations, and similar events. These are essentially corporate housekeeping provisions, but are nonetheless necessary because of the risk of injudicious case law that may not protect the investors in such situations.

The other form of anti-dilution protection insisted upon by investors is price anti-dilution. To understand how anti-dilution provisions work, first it is necessary to understand that, when the preferred shares are initially issued, the conversion ratio of preferred into common is set at one-for-one. The formula to determine the ratio is the original issue price of the preferred divided by the conversion price, which originally is the price paid so as to achieve the one-to-one ratio. When a subsequent round of financing is done, it is to be hoped that the price for the securities issued will be higher, which it will be (market conditions and all other things being equal) if the startup is succeeding. The price could also be the same or lower. If the price is the same or higher, the anti-dilution provisions do not come into play. It is only if the price in the subsequent financing is lower that the anti-dilution provisions operate to lower the conversion price so as to give the preferred shareholders a higher number of common shares upon conversion, on the rationale that this compensates them for the equity dilution suffered when the later investors buy shares for a lower price per share.

There are two basic types of price anti-dilution protection, weighted average and full ratchet. Weighted average anti-dilution mitigates the impact of the anti-dilution adjustment. In other words, weighted average anti-dilution protection accounts more accurately than does full ratchet anti-dilution for the actual dilutive effect which a particular issuance has on the investors' equity position in the startup: a more significant adjustment in the conversion ratio of the preferred shares if a larger number of shares is issued at a lower price, and a less significant adjustment if a smaller number of shares is issued at a lower price. With weighted average anti-dilution, upon a sale of shares at a price lower than the conversion price, the conversion price is lowered to a price that is an average of the price at which the company has sold shares, valuing the common shares outstanding at the pre-adjusted conversion price. An issuance of warrants, share options, or convertible securities is deemed to be a sale of the underlying shares. There is a continuum of weighted average formulas, from broad-based to narrow-based, the variation being in which common shares equivalents are included in the fully diluted base over which the dilutive effect is spread.

The harsher form, full ratchet anti-dilution, on the other hand, treats all later shares issuances below the investor's purchase price as if they were the same, resulting in the same adjustment to the conversion ratio regardless of the number of shares issued. The conversion price is ratcheted down to the lowest price at which shares are sold after the issuance of the convertible preferred, even if only one share is sold at that price. Thus, if the next round of financing is for a price that is half of the first round price, the conversion price of the original preferred will be cut in half so that the original preferred investors will receive twice as many common shares upon conversion, all for no additional consideration, resulting in significant dilution to the founders and other common shareholders. In this way, the original preferred investors are effectively –retroactively – given the lowest price at which the company's shares are sold.