Beware the Death Spiral of "Full Ratchet" Anti-Dilution

Today’s uncertain economic environment, coupled with the tightening of available capital from venture capital funds, has marked the return of a dangerous price protection device: “full ratchet” anti-dilution. This device, generally included in the terms of preferred stock issued to new investors, seeks to protect those investors from being diluted by a subsequent financing at a lower valuation — the so-called “down round” — by causing an adjustment to the applicable conversion rate for the preferred stock.¹

To understand how this works, here is an example that assumes a company issued its Series A Preferred Stock at $5.00 per share.

• These shares would ordinarily be convertible into common stock upon an initial public offering (IPO) and certain other events on a one-for-one basis — that is, upon conversion, the holder would receive one share of common stock for each share of Series A Preferred.
• The full ratchet conversion formula, however, would provide that if in the future, any additional shares of preferred stock or common stock are issued at a lower price than the per-share price paid for the Series A Preferred, then the conversion rate for the Series A Preferred shares will be adjusted so that upon conversion, the holders of Series A Preferred will receive as many shares of common stock as if they had originally purchased Series A Preferred shares at the same lower price paid for the subsequent round, regardless of the size of the round relative to prior financings.
• For example, if in the next round the Series B Preferred was issued at $2.50 per share, the full ratchet would cause the conversion rate for the Series A Preferred shares to be adjusted downward from the original $5.00 to $2.50 and the holders of Series A Preferred would be entitled to convert each share of Series A Preferred into two shares of common stock, whereas the Series B Preferred holders would receive only one share of common stock for each share of Series B Preferred. This provision “protects” the Series A Preferred investors by making sure that they will always get the benefit of the lower-priced shares issued in later financing rounds.

What is the problem with this provision? The answer is simple. From a practical standpoint, as seen in the example below, the anti-dilution protection will result in additional shares being issuable to the holders of Series A Preferred, which means that the company will have to issue more shares to the new investors to get them to the desired ownership percentage of the company. The dilutive effect on the ownership percentages of the founders and management can be severe and destabilizing for the company. As a result, most investors would not want to come in as new investors and put money in a company that has outstanding preferred stock with full ratchet anti-dilution protection because it may completely undermine the company’s valuation and destroy the value in earlier stock incentive plans. Here is why:

• Taking the previous example, assume that the Series A Preferred investors valued the company at $50 million on a post-money (i.e., after the Series A Preferred investment) basis and purchased four million shares at $5.00 per share, for a 40-percent interest in the company (total outstanding capital stock after the financing: 10 million shares, with the founders and management holding six million shares of common stock, representing 60 percent of the company).
• Next, assume that the proposed new investors value the company at $25 million on a pre-money basis and wish to invest $6.25 million for a 20-percent ownership stake in the company post-money (i.e., immediately after their investment).
• Initially, without considering the effect of the full-ratchet, the per-share price for the Series B Preferred would be $2.50 (per-share price is derived by dividing pre-money valuation by total number of shares outstanding) and in order to own 20 percent of the company post-money, the investors would purchase an aggregate of 2.5 million shares of Series B Preferred (total outstanding capital stock after the financing: 12.5 million shares).
• However, if the per-share price for the Series B Preferred is set at $2.50, the full ratchet anti-dilution mechanism is triggered, reducing the conversion price for Series A Preferred to $2.50 from $5.00 and, in effect, doubling the number of common shares issuable upon conversion of the Series A Preferred, from four million to eight million.
• Series B investors will likely not agree to such automatic dilution immediately following their investment and instead will insist that such additional “anti-dilution shares” be deemed outstanding pre-money, in which case only the existing shareholders are being diluted. If the anti-dilution shares are deemed outstanding pre-money, then the total number of shares outstanding for purposes of calculating the per-share price for Series B Preferred will increase from 10 million to 14 million which, based on a $25 million pre-money valuation, produces a per-share price for the Series B Preferred of approximately $1.78.² 
• The new per-share price of $1.78 for the Series B Preferred is lower than the Series A Preferred conversion price of $2.50 and again, the anti-dilution protection for the Series A Preferred is triggered, causing another downward adjustment to the conversion rate for the Series A Preferred to $1.78. Upon conversion, the holders of Series A Preferred shares will receive an aggregate of 2.8 shares of common stock for each share of Series A Preferred (as determined by dividing $5.00 by $1.78). As a result, the outstanding shares pre-money would increase to approximately 17.2 million,³ increasing the number of shares required for a 20-percent ownership interest in the company to 4.3 million shares of Series B Preferred and a new per-share price for the Series B Preferred of approximately $1.45.⁴ 
• However, the new per-share price of $1.45 is lower than the Series A Preferred conversion price of $1.78, which will again trigger a new anti-dilution adjustment and prompt another re-pricing of the Series B Preferred shares, and further dilute the founders and management, and so on and so on. The death spiral has begun. In the end, when the parties have agreed on a “stable” per-share price (approximately $0.84 per share in this scenario) that will not trigger the anti-dilution protection and another price adjustment for the Series B Preferred, the holders of Series A Preferred will own approximately 64 percent, the Series B Preferred 20 percent, and the founders and management are left with 16 percent.
• As illustrated above, when the full ratchet anti-dilution protection is triggered, it causes a significant realignment in the cap table, and often, early participants (e.g., founders and management) are severely diluted or washed out. The effect of the full ratchet can be very helpful, if, in connection with an “internal round” (e.g., the financing is limited to existing investors), the company and its investors disagree on the valuation of the company, in which case a full-ratchet mechanism can be used to facilitate an automatic future adjustment in the cap table if the company fails to perform or raise outside capital.

Except for the scenario where there is a strong disagreement on the valuation of the company and the investors wish to plan for an automatic realignment in the cap table as described above, the result of the full ratchet anti-dilution protection adds complexity and does not benefit the investor or the portfolio company. The alternative: Stick with the tried-and-true “weighted average anti-dilution formula.” This, too, results in an adjustment in the conversion rate and additional shares of common stock being issuable to the already outstanding preferred classes during a down round, but the impact is far more attenuated and can more easily be built into the pricing of the new series of equity. Alternatively, design the liquidation preferences to balance the interests of the investors and management or be prepared to renegotiate (read: eliminate) the full ratchet anti-dilution provisions upon a subsequent round of financing — which, of course, eviscerates the effect of those provisions. At a minimum, limit the duration during which the full ratchet anti-dilution provisions are effective (i.e., one year). After one year, holders would either have to revert to weighted average anti-dilution rights, or simply have their valuation float alongside the common shares.

Prior round investors who share in the governance and economics of their portfolio companies can decide whether, and at what price, they will allow new funds into the business. If they wish to maintain their pro-rata ownership, they can participate in future rounds. Governance and voluntary or mandatory participation in future rounds, in turn, raise other problems faced by venture investors today: Board-level fiduciary duties for investor representatives and pay-to-play requirements. These will be the subject of future Foley Legal News Alerts.

¹ The anti-dilution mechanism typically applies to other dilutive issuances as well, such as stock issuances or option grants to vendors or strategic partners.

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