Piggyback registration rights entitle investors to register their shares of common stock whenever the company conducts a public offering, subject to certain exceptions. Unlike demand rights, piggyback rights do not entitle investors to require a company to conduct a public offering but simply allow them to include shares in a registration that is initiated by the company. Piggyback registration rights typically are not particularly disruptive (other than the effort involved in contact investors with piggyback right to solicit their participation in a registration) and do not require the special effort of demand registrations. Companies usually bear the cost of investors exercising piggyback rights.

The items typically negotiated in the piggyback registration rights provision include:

• The ability of underwriters to cutback investor shares in an offering. Typically, the piggyback registration rights provisions allows underwriters to completely eliminate investors as selling shareholders in an IPO. In subsequent offerings, the investors will typically negotiate that they cannot be cutback to less than 25% or 30% of the offering.

• The priority of investor shares to be included in an offering. Some venture funds aggressively negotiate the priority of any shares that the underwriters allow to be registered in a company-initiated registration. An aggressive later investor may request that their shares be included in a registration before any other non-company shares are included in the registration.

• Whether founders and management can also have piggyback registration rights. Savvy founders will argue to obtain piggyback registration rights for the same reason that venture funds want the rights.  Absent registration, founders that are affiliates will need to comply with volume restrictions under Rule 144. A registered public offering may be one of the few orderly ways that a founder can sell a large number of shares.

Demand registration rights entitle an investor to force a company to register shares of common stock so that the investor can sell them to the public. This effectively causes the company to undertake an IPO if the company is not yet public. Registrations are time-consuming and expensive, particularly if they involve underwritten public offerings of securities. These offerings require significant efforts from management, diverting them from the business of running the company. These offerings can even depress the market price of the company’s stock if the offering is poorly timed.

As a practical matter, I have never heard of a demand registration right being exercised by an investor. Completing an offering without company and management cooperation is impossible.

The items typically negotiated in the demand registration rights provision include:

• The number of demand registrations the investor can require. Because registrations are expensive, the company typically tries to limit it to one, while the investors typically want two.

• When the investor can make a demand. In an early state financing, a demand registration cannot be exercised until five years from the closing of the financing. In a later stage financing, the time period may be much shorter, depending on the expected potential IPO-readiness date. In addition, a demand registration right typically cannot be exercised for a certain time period after an IPO, such as 180 days.

• Who pays for the demand registration and up to what amount. Typically, the company pays for registration expenses and the expenses on a single counsel to the investors (which is subject to a cap).

• The minimum dollar size of a demand registration. Given the expense involved in a registration, companies want to set some minimum requirements on a demand registration so that it is a legitimate offering. The minimum price per share to exercise a demand registration and the minimum dollar amount of the offering are typically similar to the definition of a Qualified Public Offering that causes the preferred stock to convert to common stock. This is typically set at around 3x to 5x the purchase price of the preferred stock (5x in earlier stage financings and 3x or lower in later stage financings) and an aggregate of $20M or higher to be raised in the offering.

• Rights to delay a demand registration. Companies routinely request the right to delay a demand offering for a fixed maximum period of time if the company has commenced preparations for a public offering or believe a delay would beneficial because of market or other conditions or to avoid disclosing material company developments, such as pending merger negotiations.

• Whether the company needs to use “best” efforts or “commercially reasonable” efforts to effect a registration. Investors ask for “best” efforts, which may require registration irrespective of costs or effort disproportionate to benefit. However, some commentators suggest that there is no real difference between any of these standards.

Registration rights entitle investors to force a company to register shares of common stock issuable upon conversion of preferred stock with the Securities and Exchange Commission.

Federal and state securities laws place certain limitations on the transfer of shares that have not been registered. Rule 144 of the Securities Act of 1933 requires that securities be held for at least one year before being sold.  Among other things, Rule 144 also requires that certain current public information about the company be available and limits the volume of shares that can be sold, unless the seller has held the securities for at least two years and is not an affiliate of the company.  Registration allows venture funds to freely sell the shares without complying with these restrictions even if they are deemed affiliates due to significant shareholdings or a director on the board.

Registration involves filing a registration statement with the SEC, which is a expensive and time consuming process. Please see the initial filing of Google’s registration statement for its IPO as an example of the complexity of the document. Legal, accounting and other fees in connection with an IPO can easily exceed $2M.

As a practical matter, registration rights are rarely used and have little practical effect on a company until after an IPO. However, some venture funds and attorneys seem to spend a long time negotiating these provisions, when they have little practical impact.  Registration rights are negotiated between the company and the investors, well before underwriters are involved.  At the time of an IPO and subsequent underwritten public offerings, underwriters will have the ability to dictate whether investors are allowed to sell, which makes the registration rights negotiated at the time of the venture financing a mere starting point for discussions with the company and the underwriters.

Information rights force a company to provide investors with financial statements and other company information.  These rights are typically contained in an Investor Rights Agreement.

A typical information rights provision from a term sheet provides:

The Company will deliver to each holder of at least [500,000] shares of Preferred, (i) [un]audited annual financial statements within [90] days following year-end, (ii) unaudited quarterly financial statements within [45] days following quarter-end, (iii) unaudited monthly financial statements within [30] days of month-end, and (iv) annual business plans. The information rights will terminate upon an initial public offering.

Most information rights also include the opportunity to visit the company’s facilities, inspect the company’s books and records and discuss matters with company officers.  As a practical matter, I don’t think that most venture backed companies are in 100% compliance with information rights provisions, especially the time periods for delivery of the information.  For example, audited financial statements for private companies never seem to be completed within the specified time period.

One issue that gets negotiated in the information rights provision are the number of shares that an investor needs to hold to receive information rights.  This concept of “major investor” is often used to limit the investors that receive preemptive rights and rights of first refusal and co-sale (to be covered in future posts).  The number of shares is typically set low enough to ensure that the smallest venture fund (or significant angel) in a syndicate receives information rights and high enough to avoid giving rights to numerous small investors.  In addition, companies may wish to avoid commiting to delivering annual business plans or monthly financial statements

Information rights provisions also contain provisions that ensure that investors keep the information confidential. This is important because directors have a fiduciary duty to keep company information confidential, but investors do not have a similar obligation absent a contractual confidentiality provision.

Most venture financings require the creation and issuance of a new series of preferred stock.  This typically requires an amendment of a company’s Certificate of Incorporation in Delaware (or Articles of Incorporation in California).  The stockholder vote requirements for these actions are governed by state law and the Company’s charter (COI or AOI) and bylaws.  The stockholder vote requirements under Delaware law and California law are outlined below.

Delaware

General.  Delaware corporate law provides that an amendment to the Certificate of Incorporation requires the approval of a majority of the outstanding stock entitled to vote and at least a majority of the outstanding stock of each class entitled to vote as a class.  (For example, common stock is a class, and preferred stock is a class.)  The shares and classes entitled to vote are determined by the Certificate of Incorporation.

Class Vote Requirements.  Delaware corporate law provides that a “class vote” is required if the amendment to the Certificate of Incorporation does any of the following:

• Increases or decreases the par value of the shares of the affected class(es) (subject to certain limited exceptions);
• Increases or decreases the aggregate number of authorized shares of the affected class(es); or
• Adversely affects the powers, preferences, or special rights of the shares of such class.

For the purposes of the class vote, different series of the same class are not treated as a separate class unless the amendment to the Certificate of Incorporation adversely affects the powers, preferences or special rights of such series.  The position of a class or series of shares relative to other classes or series is not a power, preference, or special right of the shares, so that the provisions granting a class vote where the powers, preferences, or special rights are affected adversely do not apply to an amendment that creates a class or series with rights, powers and preferences prior to those of one or more existing classes or series of stock.

Though not expressly required under Delaware law, the holders of common stock often have a vote when new senior preferred stock is issued.  This is because the corporation typically needs to increase the authorized number of common shares to allow for the future conversion of the newly issued preferred stock into common stock.  If the corporation already has sufficient authorized common stock to allow for the conversion of the new preferred stock, a new class of preferred stock could be created without common stockholder approval.  In addition, the number of authorized shares of common stock may be increased by a vote of the majority of the outstanding stock of the corporation if the Certificate of Incorporation allows.  Most typical Certificates of Incorporation for venture-backed companies provide for this flexibility to avoid a separate common stockholder vote in a future venture financing.

Practical answer.  Generally, the necessary stockholder approval for a venture financing for a Delaware corporation (assuming properly drafted articles avoiding a separate common vote) will be (i) a majority of all shares on an as converted to common basis (due to the general stockholder approval requirement to amend the Certificate of Incorporation under Delaware law), (ii) a majority of all preferred stock on an as converted to common basis (due to the need to authorize additional preferred stock triggering a class vote), and (iii) any other approval required by the protective provisions in the Certificate of Incorporation, such as a separate series approval or super-majority approval.

California

General.  California corporate law provides that amendments to the Articles of Incorporation require the approval of a majority of the outstanding shares.

Class Vote Requirements.  California corporate law provides that a class vote (in addition to the affirmative vote of a majority of the outstanding voting shares) is required if an amendment to the Articles of Incorporation does any of the following: 

• An increase or decrease in the aggregate number of authorized shares of such class (subject to certain limited exceptions);
• An exchange, reclassification or cancellation of any part of such class (including a reverse stock split, but excluding a forward stock split);
• An exchange, or creation of a right of exchange, of any part of such class into another class;
• A change in the rights, preferences, privileges or restrictions of the shares of such class;
• The creation of a new class of shares with rights, preferences or privileges prior to the shares of such class or an increase in the rights, preferences or privileges or the number of authorized shares of any class with rights, preferences or privileges prior to the shares of such class;
• Dividing any class of preferred shares into series having different rights, preferences, privileges or restrictions or authorizing the Board of Directors to do so; or
• The cancellation of or otherwise affecting accrued, unpaid dividends.

For the purposes of the class vote, different series of the same class are not treated as different classes unless such series are affected by an amendment to the Articles of Incorporation differently than other series of the same class.

Practical answer.  Generally, the necessary shareholder approval for a venture financing of a California corporation will be (i) a majority of all shares on an as converted to common basis (due to the general stockholder approval requirement to amend the Articles of Incorporation under California law), (ii) a majority of all common stock (due to various provisions triggering a class vote), (iii) a majority of all preferred stock on an as converted to common basis (due to various provisions triggering a class vote), and (iv) any other approval required by the protective provisions in the articles of incorporation, such as a separate series approval or super-majority approval.  The fact that holders of common need to approve an amendment of the Articles of Incorporation to facilitate a typical venture financing for a California corporation is one reason why venture funds prefer Delaware.  Venture funds don’t want common holders to have the ability to block a future financing.

(Side note:  For some reason, it’s “stockholders” in Delaware and “shareholders” in California.  One bit of assorted trivia in case anyone cares.)

Protective provisions give the preferred stock or a series of preferred stock the ability to block certain company actions.

Typical preferred stock protective provisions

Typical preferred stock protective provisions from a term sheet may include:

So long as [any] of the Preferred is outstanding, consent of the holders of at least [50]% of the Preferred will be required for any action that (i) alters any provision of the certificate of incorporation [or the bylaws] if it would [adversely] alter the rights, preferences, privileges or powers of or restrictions on the preferred stock or any series of preferred; (ii) changes the authorized number of shares of preferred stock or any series of preferred; (iii) authorizes or creates any new class or series of shares having rights, preferences or privileges with respect to dividends or liquidation senior to or on a parity with the Preferred or having voting rights other than those granted to the preferred stock generally; (iv) approves any merger, sale of assets or other corporate reorganization or acquisition; (v) approves the purchase, redemption or other acquisition of any common stock of the Company, other than repurchases pursuant to stock restriction agreements approved by the board upon termination of a consultant, director or employee; (vi) declares or pays any dividend or distribution with respect to the [preferred stock (except as otherwise provided in the certificate of incorporation) or] common stock; [or] (vii) approves the liquidation or dissolution of the Company[; (viii)increases the size of the board;] [(ix) encumbers or grants a security interest in all or substantially all of the assets of the Company in connection with an indebtedness of the Company;] [(x) acquires a material amount of assets through a merger or purchase of all or substantially all of the assets or capital stock of another entity;] [or (xi) increases the number of shares authorized for issuance under any existing stock or option plan or creates any new stock or option plan].

These protective provisions are typically contained in the certificate of incorporation of a Delaware company.  I think provisions (i) through (vii) are fairly standard (although I think some of the provisions in brackets are not necessarily standard).  I think that provisions (viii) to (xi), along with anything not listed above, are investor favorable and not as typical in West Coast venture financings.  However, all of these provisions are subject to discussion depending on the negotiation strength of the parties.

Minimum threshold to maintain protective provisions

The company should argue for a minimum number of outstanding shares of preferred stock to maintain protective provision.  For example, if only one share of preferred stock remains outstanding as a result of redemptions or optional conversions to common stock, the holder of the one share should not have the ability to block certain company actions.  However, many protective provisions say that they are effective as long as “any” shares are outstanding.

Voting threshold for protective provisions

The necessary vote to bypass the protective provision is typically set at 50%.  In many cases, the percentage is set higher, such as 66 2/3%, because the investor group consists of multiple investors, and a fund or group of funds that holds a significant amount of the preferred want to ensure that a sufficient percentage of preferred shareholders favor the action.

“Series” protective provisions

Upon a Series B or later financing, the later round may request a separate protective provision.  The company generally would prefer that the preferred stock have a single protective provision as a group, rather than each series of preferred stock having its own protective provision.  A separate protective provision may make sense in a later round of financing where the investor is also receiving a senior (as opposed to pari passu) liquidation preference.  However, the company and investors will want to ensure that a series of preferred stock that represents a small percentage interest of the company or represents a small dollar amount of investment does not receive a separate protective provision.

Board level protective provisions

In some cases, investors request additional board level protective provisions.  The board level protective provisions from the sample investor-favorable NVCA term sheet are:

[So long as [__]% of the originally issued Series A Preferred remains outstanding] the Company will not, without Board approval, which approval must include the affirmative vote of [____] of the Series A Director(s):  (i) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the Company; (ii) make any loan or advance to any person, including, any employee or director, except advances and similar expenditures in the ordinary course of business or under the terms of a employee stock or option plan approved by the Board of Directors; (iii) guarantee, any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business; (iv) make any investment other than investments in prime commercial paper, money market funds, certificates of deposit in any United States bank having a net worth in excess of $100,000,000 or obligations issued or guaranteed by the United States of America, in each case having a maturity not in excess of [two years]; (v) incur any aggregate indebtedness in excess of $[_____] that is not already included in a Board-approved budget, other than trade credit incurred in the ordinary course of business; (vi) enter into or be a party to any transaction with any director, officer or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such person [except transactions resulting in payments to or by the Company in an amount less than $[60,000] per year], [or transactions made in the ordinary course of business and pursuant to reasonable requirements of the Company’s business and upon fair and reasonable terms that are approved by a majority of the Board of Directors]; (vii) hire, fire, or change the compensation of the executive officers, including approving any option plans; (viii) change the principal business of the Company, enter new lines of business, or exit the current line of business; or (ix) sell, transfer, license, pledge or encumber technology or intellectual property, other than licenses granted in the ordinary course of business.

These provisions are not common in West Coast venture financings, but are more common in East Coast venture financings, and standard in venture financings for Cayman incorporated Chinese companies.  As a practical matter, almost all of these provisions will require board approval anyway for good corporate governance.  The issue is whether the Series A director(s) should have the ability to veto these actions despite majority board approval.  This type of control might be reasonable in the context of a joint venture, but may not be reasonable when the Series A director only represents a small fraction of the outstanding shares.

Board level protective provisions are usually placed in the investor rights agreement or document other than the certificate of incorporation.  If these provisions were placed in the articles of incorporation of a California company, the California Secretary of State would reject the articles on the theory that this gives the Series A director more power than other directors.

Drafting issues

Investors wanting protection through protective provisions must make sure that the provisions are drafted carefully and clearly.  In the WatchMark (2004) and Benchmark (2002) cases in Delaware, the certificates of incorporation clearly required the consent of the opposing stockholders to amend their terms as contemplated by a proposed financing. However, the same approval was not necessary for an amendment effected through a merger (with a subsidiary).  Thus, the companies were allowed to achieve a result indirectly that was otherwise prohibited under the protective provisions.  To avoid this result, the certificates of incorporation should have specifically prohibited changes to preferred stock terms “whether effected, directly or indirectly, by means of an amendment, merger, consolidation or otherwise.”

All rights in preferred stock provisions, even if considered standard or customary, must be “expressly and clearly stated.” Courts in Delaware will not imply or presume meaning or language from other provisions of the charter.

In addition, most certificates of incorporation contain a “no impairment” clause. These clauses are provisions that generally prohibit a company from seeking to avoid or impair the rights of the preferred stock. The WatchMark court held that no impairment clauses, like other preferred stock provisions, will be interpreted very strictly. A generic “no-impairment” clause will not provide the preferred stock with any particular protection beyond what is specifically provided in the certificate of incorporation.

A company will want to ensure that certain types of stock issuances do not trigger anti-dilution protection.  This is especially true with full-ratchet anti-dilution protection because the issuance of even 1 share at a price lower than a series of preferred stock will result in an adjustment of the conversion price of all shares of that series of preferred stock.

A list of company-favorable carveouts to anti-dilution protection from a term sheet may include:

There will be no adjustment to the conversion price for issuances of (i) shares issued upon conversion of the Preferred; (ii) shares or options, warrants or other rights issued to employees, consultants or directors in accordance with plans, agreements or similar arrangements, but not to exceed a total of [__________] shares issued after the closing date [or such greater number as unanimously approved by the board]; (iii) shares issued upon exercise of options, warrants or convertible securities existing on the closing date; (iv) shares issued as a dividend or distribution on Preferred or for which adjustment is otherwise made pursuant to the certificate of incorporation (e.g., stock splits); (v) shares issued in connection with a registered public offering; (vi) shares issued or issuable pursuant to an acquisition of another corporation or a joint venture agreement approved by the board; (vii) shares issued or issuable to banks, equipment lessors or other financial institutions pursuant to debt financing or commercial transactions approved by the board; (viii) shares issued or issuable in connection with any settlement approved by the board; (ix) shares issued or issuable in connection with sponsored research, collaboration, technology license, development, OEM, marketing or other similar arrangements or strategic partnerships approved by the board; (x) shares issued to suppliers of goods or services in connection with the provision of goods or services pursuant to transactions approved by the board; or (xi) shares that are otherwise excluded by consent of holders of a majority of the Preferred.

Investors and the company will argue about the scope of the carveouts and potentially the number of shares in any given careveout.  In order for some of the carveouts to apply, the investors may require that the issuance of stock be unanimously approved by the board or approved by the directors nominated by the preferred stock.

A company generally wants flexibility in the carveouts to avoid anti-dilution protection being triggered and bothersome amendments to the certificate of incorporation to waive anti-dilution adjustments.  Although an anti-dilution adjustment may be waived by a specific shareholder, I’m not sure the waiver would be valid against a subsequent holder of the shares that did not know about the waiver.  Therefore, a properly drafted certificate of incorporation should allow for the waiver of an anti-dilution adjustment upon a certain vote of the preferred stock or applicable series of preferred stock, without the need to amend the certificate of incorporation.

A solution to incentivize investors to participate in a financing is called the “pay to play” provision.  Basically, investors that do not participate to their full pro-rata percentage of the financing are punished by losing certain rights.

Pay to play provisions tied to dilutive financings provide that only investors that participate in the dilutive financing are entitled to the benefit of the anti-dilution formula in effect.  Investors that do not participate do not receive any anti-dilution protection.  This technique is beneficial for both for the company and for the investor group because it encourages all investors to continue to fund the company during those times when such incentive is most needed, i.e., when the company is undertaking a difficult financing.

The incentive to participate in a dilutive financing can be strengthened by a variation on the pay to play concept.  Instead of merely losing anti-dilution protection with regard to the initial dilutive financing in which the investor does not participate, the investor loses anti-dilution protection with regard to such initial financing and all subsequent dilutive financings which may occur.  Mechanically, this can be accomplished by creating a “shadow” series of preferred stock identical in all respects to the original series but without any anti-dilution protection.  In the event that an investor fails to participate in a dilutive financing, all shares of preferred stock held by such investor are automatically converted into the shadow preferred.

Another harsher variant of the pay to play concept provides that upon an investor’s failure to participate in a dilutive (or potentially any) financing, such investor’s preferred stock is converted into common stock with the result that such investor will lose not only its anti-dilutive protection, but also its liquidation preference and other special rights of the preferred.  This approach may appear to be somewhat draconian, as it seems unfair where a particular investor may be unable to participate due to circumstances outside of its control.  This may be especially applicable to funds out of money, or strategic investors or angels that do not expect to participate in subsequent rounds.  Most investors do not want to give up the liquidation preference and preferred rights other than anti-dilution protection merely because they decided not to participate in a particular dilutive financing.

A disadvantage of the automatic conversion approach, whether into common stock or preferred stock, is that once an investor has been converted, the pay to play provision provides no further incentive for that investor to participate in the next dilutive financing.  If the goal for the company and the lead investors is to maximize the incentive for all investors to participate in all dilutive financings, the better approach would be to provide that if an investor fails to participate in the initial dilutive financing, such investor receives no anti-dilution protection with regard to such financing, but in the event that such investor elects to participate in a subsequent dilutive financing, such investor would be entitled to anti-dilution protection with regard to such subsequent financing.  Although this formula can be implemented with regard to multiple dilutive financings by creating several series of shadow preferred, each having a different conversion rate, this approach results in a very complicated capital structure for the company which can become overly cumbersome.

Another approach involves providing for a “springing warrant” which is then issued to each investor that participates in a dilutive financing.  This warrant is exercisable (at a nominal exercise price) for the additional number of shares of common stock equal to the number of additional shares which the applicable anti-dilution formula would allocate to such investor.  This approach results in a simpler capital structure for the company as it avoids the necessity of creating the shadow series of preferred.

The pay to play concept is based upon requiring participation by the investor in the dilutive financing.  The appropriate level of participation needs to be carefully considered.  Pay to play clauses are often written to require each investor to participate in the dilutive financing to the extent of its percentage ownership of the company.  Although this is typically the amount of the financing which the investors are entitled to purchase by reason of their contractual rights of first refusal, this approach may not work properly because the sum of the ownership percentages of the various investors will be less than 100%, and the primary purpose of the pay to play clause is to assist the company in raising the total amount of financing which it requires.  Requiring each investor to purchase a percentage of the dilutive financing equal to its pro rata ownership among the investor group won’t quite work either because the sum of these percentages will always be 100%, leaving no room for a potential new investor.

Conceptually, the optimal approach is to require each investor to purchase a percentage equal to its pro rata ownership among the investor group of that portion of the financing allocated to the existing investors by the board of directors of the company, with the balance of the financing (if any) being purchased by the new investors.  Under this formula, if all of the preceding investors participate, together with any new investors, the company will receive 100% of the funds it is seeking to raise.  If the required percentage is higher than the percentage which such investor has a contractual right to purchase, the company must offer the investor the opportunity to purchase this greater amount in order to implement the pay to play clause.

[Note:  this post and others on anti-dilution are based on (and complete sections of text copied from) an article titled “The Venture Capital Anti-Dilution Solution” written by Mike O’Donnell and Anton Commissaris.]

Full ratchet anti-dilution protection is conceptually much simpler than the weighted average approach, and its effect on the company is considerably more severe in the event of a dilutive financing.  Under the full ratchet formula, the conversion price of the preferred stock outstanding prior to such financing is reduced to a price equal to the price per share paid in the dilutive financing.

For example, if the outstanding preferred stock was previously sold at a price of $1.00 per share, and the new preferred stock in the dilutive financing is sold at a price of $0.50 per share, the effective price of the previously outstanding preferred stock would be reduced to $0.50 per share with the result that each share of such preferred stock previously convertible into one share of common stock would now be convertible into two shares of common stock.

Under the full ratchet formula, this same result is obtained whether the company raises $100,000 at a price of $0.50 per share or raises $10,000,000 at a price of $0.50 per share. In contrast, the amount of money raised in the dilutive financing is an important factor in determining the new conversion price in the weighted average formula.

Below is an example of how full-ratchet anti-dilution protection works.

Assume that the pre-financing capitalization of the company is (same as example for weighted average anti-dilution protection):

1,500,000  Common Stock

2,500,000  Series A Preferred Stock (issued at $1/share)

2,000,000  Series B Preferred Stock (issued at $2/share)

1,000,000  Options

7,000,000  Total

Also assume that there is a dilutive financing with the issuance of 2,000,000 shares of Series C Preferred Stock at $0.50 per share, for total gross proceeds of $1,000,000.

Series A adjustment

The Conversion Price of Series A Preferred Stock becomes $0.50.

Thus, the number of shares of common stock issuable upon conversion of Series A Preferred Stock =

(2,500,000) * ($1.00/$0.50) = 5,000,000

This results in a Series A Conversion Rate of 2:1

Series B adjustment

The Conversion Price of the Series B becomes $0.50.

Thus, the number of shares of common stock issuable upon conversion of Series B Preferred Stock =

(2,000,000) * ($2.00/$0.50) = 8,000,000

This results in a Series B Conversion Rate of 4:1

Problems with the full ratchet

At first glance, the full ratchet formula seems very attractive for investors as it completely protects their investment from any subsequent price erosion until the occurrence of a liquidity event (at which time the preferred stock would normally be converted to common stock). The company should argue that it is unfair to have the company bear all the downside price risk where there is no limit on the upside potential for the investors.

However, a full ratchet formula can also be problematic for the investors in a syndicate.  Because the prior money invested is fully protected with regard to price decreases, if the company’s prospects deteriorate and the company is forced to undertake a dilutive financing, there is no incentive for all of the investors to participate in the new dilutive round.  Therefore, the lead investor(s) may have difficultly inducing the smaller investors in the syndicate to continue to participate, and the burden of continuing to fund the company can fall heavily on the lead investor(s).  In addition, the application of the full ratchet will be disclosed to the incoming invstors in the new round upon review of the company’s charter documents in the due diligence process.  This will make the company appear significantly less attractive to invest in and will exacerbate the problems of an otherwise already difficult financing.  Because the number of pre-financing shares outstanding increases due to the anti-dilution adjustment, the price per share of the new series of preferred stock will decrease.  This results in a circular formula, that requires strong spreadsheet skills to solve.

In addition, as a result of the anti-dilution protection for the preferred stock, the percentage ownership of the common stock will decrease, which decreases the incentive of management and employees.

[Note:  this post and others on anti-dilution are based on (and complete sections of text copied from) an article titled “The Venture Capital Anti-Dilution Solution” written by Mike O’Donnell and Anton Commissaris.]

The most common anti-dilution protection is called “weighted average” anti-dilution protection. This formula adjusts the rate at which preferred stock converts into common stock based upon (i) the amount of money previously raised by the company and the price per share at which it was raised and (ii) the amount of money being raised by the company in the subsequent dilutive financing and the price per share at which such new money is being raised. This weighted average price (which will always be lower than the original purchase price following a dilutive financing) is then divided into the original purchase price in order to determine the number of shares of common stock into which each share of preferred stock is then convertible, which will be greater than one. Thus, a new reduced conversion price for the preferred stock is obtained, which results in an increased conversion rate for the preferred stock when converting to common stock.

If new stock is issued at a price per share lower than the conversion price then in effect for a particular series of preferred stock, the conversion price of such series will be reduced to a price determined by multiplying the conversion price by the following fraction:

[Common Outstanding pre-deal] + [Common issuable for amount raised at old conversion price]

[Common Outstanding pre-deal] + [Common issued in deal]

There are two primary variations of the weighted average formula depending on what constitutes “Common Outstanding” in the above formula. The first, and more common, is referred to as “broad-based weighted average” while the second is referred to as “narrow-based weighted average.”

Broad-based weighted average formula

The calculation of “Common Outstanding” in the broad-based formula includes all shares of common stock and preferred stock (on an as-converted to common basis) outstanding, common issuable upon exercise of outstanding options, common reserved for future issuance under the company’s stock option plan and any other outstanding convertible securities, such as warrants.

Below is an example of how broad-based anti-dilution protection works.

Assume that the pre-financing capitalization of the company is:

1,500,000  Common Stock

2,500,000  Series A Preferred Stock (issued at $1/share)

2,000,000  Series B Preferred Stock (issued at $2/share)

1,000,000  Options

7,000,000  Total

Also assume that there is a dilutive financing with the issuance of 2,000,000 shares of Series C Preferred Stock at $0.50 per share, for total gross proceeds of $1,000,000.

Series A adjustment

The Series A Conversion Price will be adjusted as follows:

Series A Conversion Price = $1.00 multiplied by

[Common outstanding prior to deal] + [Common issuable for amount raised at old conversion price]

[Common outstanding prior to deal] + [Common issued in deal]

= 7,000,000 + 1,000,000

   7,000,000 + 2,000,000

= $1.00 * (8/9) = $0.88

Thus, the number of shares of common issuable upon conversion of Series A is:

(2,500,000) x ($1.00 / 0.88) = 2,812,500

This results in a Series A Conversion Rate of 1.125:1

Series B adjustment

The Series B Conversion Price will be adjusted as follows:

Series B Conversion Price = $2.00 multiplied by

[Common outstanding pre-deal] + [Common issuable for amount raised at old conversion price]

[Common outstanding pre-deal] + [Common issued in deal]

= 7,000,000 + 500,000

   7,000,000 + 2,000,000

= $2.00 * (7.5 / 9) = $1.67

Thus, the number of shares of common issuable upon conversion of Series B is:

(2,000,000) x ($2.00 / $1.67) = 2,400,000

This results in a Series B Conversion Rate of 1.20:1

Narrow-based weighted average formula

The narrow-based formula only includes the common stock issuable upon conversion of the particular series of shares of preferred stock in “Common Outstanding” in the formula. The narrow-based formula can be stated as follows:

Common Outstanding = Only the number of shares of the series of Preferred that is being adjusted.

Another version of the narrow-based formula would include the common stock issuable upon conversion of all shares of preferred stock outstanding in the Common Outstanding.

The effect of including the additional shares in the broad-based formula reduces the magnitude of the anti-dilution adjustment given to holders of preferred stock as compared to the narrow-based formula. The narrow-based formula provides a greater number of additional shares of common stock to be issued to the holders of preferred stock upon conversion than the broad-based formula. The extent of the difference depends upon the size and relative pricing of the dilutive financing as well as the number of shares of preferred stock and common stock outstanding.

Using the same example, the narrow-based formula works as follows:

(Common Outstanding = Common issuable upon conversion of particular series of preferred stock)

Series A adjustment

The Series A Conversion Price will be adjusted as follows:

Conversion Price of Series A = $1.00 multiplied by

[Common outstanding pre-deal] + [Common issuable for amount raised at old conversion price]

[Common outstanding pre-deal] + [Common issued in deal]

= 2,500,000 + 1,000,000

   2,500,000 + 2,000,000

= $1.00 * (3.5/4.5) = $0.77

Thus, the number of shares of common stock issuable upon conversation of Series A Preferred Stock =

(2,500,000) x ($1.00/$0.77) = 3,214,285

This results in a Series A Conversion Rate of 1.29:1

Series B adjustment

The Series B Conversion Price will be adjusted as follows:

Conversion Price of Series B Preferred Stock = $2.00 multiplied by

[Common outstanding pre-deal] + [Common issuable for amount raised at old conversion price]

[Common outstanding pre-deal] + [Common issued in deal]

= 2,000,000 + 500,000

   2,000,000 + 2,000,000

= $2.00 * (2.5 / 4.0) = $1.25

Thus, the number of shares of common stock issuable upon conversation of Series B Preferred Stock =

(2,000,000) x ($2.00/$1.25) = 3,200,000

This results in a Series B Conversion Rate of 1.6:1

Variations on weighted average formula

There are variations on both the traditional broad-based and narrow-based weighted average formulas. Among such variations is what might conveniently be called the “middle” formula. The difference depends on what constitutes “Common Outstanding.” The middle formula can be written as follows:

Common Outstanding = only common stock and preferred stock (on an as-converted to common basis) outstanding (in other words, don’t include common issuable upon conversion/exercise of debt, options and warrants).

Another company favorable variation of the weighted average formula that I have never seen in practice involves upward and downward conversion price adjustments if shares are issued at prices both greater and lesser than the applicable conversion price, although the conversion price will never be greater than the original purchase price of the preferred stock.

Once again, this proves that startup company lawyers need strong math skills.  If someone spots something wrong with the math, please let me know.

[Note:  this post and others on anti-dilution are based on (and complete sections of text copied from) an article titled “The Venture Capital Anti-Dilution Solution” written by Mike O’Donnell and Anton Commissaris.]