Page 11
Venture capital investors often require anti-dilution protection rights to protect the
value of their stake in the company, if new shares are issued at a valuation which is
lower than that at which they originally invested (a down round). This protection
usually functions by applying a mathematical formula to calculate a number of new
shares which the investors will receive, for no or minimal cost, to offset the dilutive
effect of the issue of cheaper shares.
There are several variations of the formula, each providing different degrees of
protection. These include full ratchet protection, which will result in additional shares
being issued to the investor to either maintain its percentage ownership at the same
level or so that its effective price per share is the same as the share price for the
down round. Other versions of the formula provide some compensation for the
dilution, but allow the ownership percentage to fall, most commonly by a weighted
average formula. The level of protection required by an investor depends on several
factors, including the valuation of the company at the time of the investment and the
perceived exposure to further financing requirements.
While the basic concept remains the same, there are several different mechanisms
used to create this protection. One mechanism is adjusting the conversion ratio of
preferred shares to ordinary shares to adjust for dilution. Other methods include the
issue of shares for a nominal sum or by way of bonus issue. Another method would
involve the granting of options (or warrants as they are sometimes referred to), which
are only exercisable if the anti-dilution provision is triggered.
In the example set out in Box 2 of Part III, if the project did not proceed as well as
expected and, when the time came to raise another round from new investors, it
emerged that these potential new investors were only prepared to invest at a pre-
money valuation (for them) of $200,000, this would imply that they would only pay
$1,000 per share ($200,000/200). However the existing investors paid $2,000 per
share and therefore, under full anti-dilution provisions, their shareholding would be
adjusted in order to issue them with new shares, the effect of which would be to
reduce the price they paid for the 'A' shares to $1,000 per share.
The result of the full anti-dilution provisions is that the existing investors would have to
be issued with a further 100 shares to bring their shareholding to 200 for which they
paid a total of $200,000 which equals $1,000 per share. In terms of the overall
shareholding, this would alter the ownership of the business between the founders,
academic institution and investors to 50 shares: 50 shares: 200 shares or
16.6%:16.6%:66.6% (a change from 50 shares: 50 shares: 100 shares or
25%:25%:50%).
9. Founder shares
Founders and senior management are usually central to the decision of venture
capital investors to put money into a company. Having decided to put money behind
a management team they have confidence in, investors are usually keen to ensure
that the founders remain to deliver their business plan. Therefore, it is often the case
that founders and key managers (and sometimes all shareholders/employees who
leave the company within a certain period of time) are required to offer to sell their
shares back to the company or to other shareholders. The price paid for the shares
may depend upon circumstances of departure. It may be at market value if the
founder/manager is deemed to be a good leaver, or it might be considerably less in
the case of a bad leaver. Someone who has breached his contract of employment