Monday, November 12, 2012

Antidilution Protection FAQs

"Dilution" is a very frequently heard word in startup circles. And I think most people have a pretty good general sense of what dilution is--it's when you have a piece of the pie and something happens which decreases your piece.

What I think is less understood, are (1) the implications of something happening which results in dilution to existing equity holders, and (2) the rights to protect against the resulting dilution (also known as "antidilution protection").

What Triggers a Dilutive Event.

So what has to happen to decrease your piece? Let's run through the simple algebraic analysis first. You (the founder or the investor) have x shares and the company has a total of y shares outstanding. So your piece is x/y. Then the company issues more shares so that it has y+n total shares outstanding, but you still have only x shares. x/y > x/(y+n), so you had a higher percentage of the company before the dilutive issuance.

But now let's see what's happening from a business perspective. Why is the company issuing more shares? Not every dilutive issuance is equal in its impact on the company. If the issuance serves to increase the value of the company, your smaller piece of the pie might in fact have a higher value than the bigger piece of the smaller pie that you had before.

    Example: Suppose you are a 10% equity holder in a company valued at $5,000,000. The company subsequently raises another $5,000,000 at a $15,000,000 pre-money valuation--a dilutive event. Prior to the financing you have 10% of $5,000,000, which is $500,000, and post financing you have 7.5% of a $20,000,000 company, which is $1,500,000. Your stake decreased, and your percent ownership was diluted, but you are doing ok!

The example above demonstrates that what you should watch out for is not securities issuances which dilute your percentage interest, but securities issuances that decrease your total value. The latter are the instances where equity is being issued without a corresponding increase in the value of the company. Examples of those might be (a) warrants with a low exercise price that are issued as part of a loan transaction, (b) shares issued to investors at a discount or a price lower than the company's last valuation, or (c) shares issued to employees.

Protection Against Antidilution.

Now that we know how to distinguish between different kinds of dilution, how do we protect against the bad kind, the kind that dectracts from your value?

As disappointing as this may be for founders and other holders of common stock to hear, really the only equity holders who ever get antidilution protection are the investors (holders of preferred stock). I am sure there are exceptions to this rule, in the way that there are exceptions to every rule. But 99.99% of the time this holds true.

It may not seem fair to someone who has earned his sweat equity with... well, sweat and hard work. But investors are the ones that pay the full market price for their shares (usually 3x or more the price of Common Stock), and they are the ones who are more typically able to successfully negotiate some protection for themselves. Note, however, that even their protection does not lock their initially purchased percentage for perpetuity. Generally speaking, with each new sale of securities, their percentage, too, will be effected. However, they will get an adjustment (the conversion rate at which they Preferred Stock converts into Common Stock will increase, such that the same number of Preferred shares will be convertible into more shares of Common Stock) for issuances made at a price below their entry point, with certain exceptions. The list of exceptions to investors' antidilution protection is frequently the subject to heavy negotiation between company and investors' counsel.

Happy company making!

Inna


White Summers  Inna Efimchik at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.
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