Equity Dilution in Funding Rounds
Full-ratchet? Weighted ratchet? Down rounds? If it sounds like we're talking a foreign language, then you're not familiar with the concept of antidilution clauses -- and you should be if you're thinking about pursuing investment opportunities with venture capitalists.
Company founders and venture capitalists have a love-hate relationship.
Even though founders welcome and even court the attention of venture capitalists, they resent the control VCs exert when it comes to protecting their ownership shares in subsequent funding rounds.
Venture capitalists, on the other hand, feel justified in defending their equity share in the company. After all, without the injection of venture capital during the startup phase the company would never have gotten off the ground. As early investors, VCs argue that since they took the most risk, their ownership shares should be protected.
Subsequently, VCs often insert antidilution clauses into investment contracts. Whenever a company sells equity, the current stockholders experience dilution, i.e. their percentage of ownership in the company is reduced. The impact of an equity sale is particularly acute in a "down round" of investment, a situation in which new shares of stock are sold at a price per share that is lower than the price paid in previous investment rounds. Without a remedy, VCs and early investors end up owning shares that have the same value as later investors, despite the fact that they were purchased at a higher price.
Antidilution clauses are designed to protect investors' ownership shares during additional funding rounds. Also known as "price protection", antidilution gives VCs the benefit of reduced price per share purchases or stock conversions in down rounds. Antidilution clauses are negotiated on a case by case basis and typically fall into two categories:
- Full Ratchet Antidilution Price Protection - Full ratchet is the most beneficial form of antidilution protection for the VCs and investors who receive it. When a down round occurs, full ratchet investors have the ability to convert their preferred stock to common stock at the new price which substantially increases the number of shares they own, but leaves their ownership percentage of the business intact. Dilution still occurs – it's just carried by company founders and common stock shareholders.
- Weighted Ratchet Antidilution Protection - Weighted ratchet antidilution is more complicated than full ratchet antidilution, but it's also more commonplace. It's sometimes called "formula" antidilution because it uses on semi-complicated mathematical gymnastics to calculate the price at which early investors can convert common stock to preferred stock. Even though there are a couple of variations, weighted ratchet antidilution reduces everyone's ownership percentage in the business while still offering investors an attractive (but not fully-ratcheted) price for the conversion of preferred stock to common stock.
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