WHAT IS DILUTION?


Dilution scares the shit out of entrepreneurs. This is because they don't understand what dilution is and how it works. 

The fact of the matter is that dilution happens. But if you understand it  and how it works, you can plan for it within your SYSTEM and minimize its impact.

What follows is a thorough discussion on dilution. If you're short on time, read the summary and tips for founders at the end of the article for now. You'll be ahead of 90% of the people from that alone. Come back to the body of the article later when you're ready. 

TABLE OF CONTENTS

I. MEANING OF DILUTION

A. Dilution means that your ownership percentage of the company gets lowered
B. Dilution is reality but it's not the end of the world
C. Dilution concerning Texas startups

II. ANTI-DILUTION PROTECTION

A. Investors, not founders, get anti-dilution protection
B. Anti-dilution protection for investors causes founders to get even more diluted

III. DIFFERENT KINDS OF ANTI-DILUTION PROTECTION

A. Structural anti-dilution
B. Preemptive rights/pro-rata rights
C. Price-based anti-dilution protection

IV. PRICE-BASED ANTI-DILUTION BACKGROUND

A. Conceptual Example
B. Rationale

V. MECHANICS OF PRICE-BASED ANTI-DILUTION PROTECTION

A. Background Concepts of Conversion Price

1. There are different kinds of ownership shares in a company
2. Preferred stock can convert into common stock at a certain ratio
3. Voting and some other matters of the company are often calculated on an "as-converted-basis"

VI. DIFFERENT PRICE-BASED ANTI-DILUTION METHODS

A. Rational behind different price adjustment methods
B. Full Ratchet method
C. Weighted Average method

VII. PRICE-BASED ANTI-DILUTION FORMULAS

A. Conversion Ratio
B. Full Ratchet
C. Broad-based weighted average
D. Narrow-based weighted average

VIII. PRICE-BASED ANTI-DILUTION EXAMPLES

A. Scenarios
B. Takeaways from examples

IX. EXCEPTIONS AND CARVE-OUTS
X. ACCOMPANYING ANTI-DILUTION PROVISIONS WITH PAY-TO-PLAY PROVISIONS
XI. TAKEAWAYS AND SUMMARY OF WHAT IS DILUTION
XII. TIPS FOR FOUNDERS REGARDING DILUTION

 

ARTICLE

I. MEANING OF DILUTION

A. Dilution means that your ownership percentage of the company gets lowered

Dilution occurs when the company issues additional stock to others. Each existing stockholders' proportion of stock goes down. 

When you get diluted, you do NOT get less stock. You do NOT get stock taken away from you. It's about percentage.

You own 100% of a company. Forget about the specific number of stock. You have every bit of it. Someone comes by and gives a few bucks to the company in exchange for 25% of the company and stock is issued to him from the company. You now only have 75% of the company. You had 100%. 

Your ownership of the company got diluted

There can only be 100% of company, and whenever more stock gets dished out for whatever reason, you will own less as a percent of it; i.e., you get diluted. 
 

B. Dilution is reality but it's not the end of the world

Dilution WILL happen if you raise money by selling investments in the company. There is no way around this. Your percentage of ownership WILL go down. 

There are ways to limit dilution for investors who have invested in the company with certain types of "anti-dilution protection," but founders of a company, who usually hold common stock, don't receive this type of protection.  

So dilution is simply the reality of the situation for founders. Yes, getting diluted can suck, but getting diluted can also be an indicator of good things happening and that things are going well. 

This is because it's better to have a small part of something rather than a large part of nothing.

If people are paying 100x for some of the pie you have, even if your portion of the pie is smaller, you're fine because your portion of the pie is worth a lot now. 

C. Dilution concerning Texas startups

As a startup lawyer in Houston, Texas and Dallas, Texas I want to make a quick note regarding dilution and Texas startups. The concepts presented in this article are pretty much true for startups anywhere. These really aren't jurisdictional issues so to speak. 
 

II. ANTI-DILUTION PROTECTION
 

A. Investors, not founders, get anti-dilution protection

All stockholders will get diluted when stock of the company is dished out subsequently to others. These stockholders that get diluted include founders and investors. However, investors can limit how much they get diluted because they get certain anti-dilution protection. These are certain rights that some investors receive in conjunction with their preferred stock (founders get common stock.) 

When anti-dilution protection kicks in for preferred stockholders, other stockholders (i.e. founders and common stockholders) of the company get diluted even more. Different formulas are used to figure out exactly how much everyone gets diluted. The mathematics of this is explained later in this article. 
 

B. Anti-dilution protection for investors causes founders to get even more diluted

Anti-dilution protection is a way of, when facing more stock of the company being dished out, an investor/preferred stockholder being able to say: "I want to still keep 25% of the company." 

What is the effect of this? 

That person gets to keep 25% of the company, but the other owners' percentage of the company gets lowered even more than otherwise. 

[A small caveat here: The situation described where the investor wants to maintain a certain percent no matter what, i.e. "I keep 25% of the company," is called absolute anti-dilution protection or non-dilution protection. It's rare and investors should never get this type of right.] 

What investors get more often is anti-dilution protection that helps minimize dilution for them and dilutes others more. Or they may also have anti-dilution protection that only kicks in for certain circumstances. 

So why in the world should founders or those without anti-dilution protection care about all of this anti-dilution stuff? 

Because the founder's ownership percentage dilutes more or less depending on whether or not investors have anti-dilution protection and depending on what kind of protection (i.e. what type of formula is used.)
 

III. DIFFERENT KINDS OF ANTI-DILUTION PROTECTION

There are a few different kinds of anti-dilution protection provisions.

A. Structural anti-dilution

Structural anti-dilution protection helps to keep relative ownership of stockholders the same in the case of stock splits, stock dividends, and other similar operations. For example, if the company decides that the stock price of the company is too high and wants to do a 2 for 1 stock split, a type of structural anti-dilution mechanism comes into play. Stockholders will be provided an additional share for each share of stock they have. 

This type of structural anti-dilution protection is fairly normal.

B. Preemptive rights/pro-rata rights

These are certain types of anti-dilution protection rights that kick in for an investor when a company goes out to raise more capital. Preemptive rights are sometimes also called Right of First Offer or Pro-rata Right. It's a right to maintain proportionate ownership in future financings. 

Whenever more capital is being raised an investor who has already invested in the company and has a preemptive right is able to purchase its pro-rata share in the financing in order to not get diluted. 

This is relatively basic protection for investors.

1. SUPER PRO-RATA RIGHTS

Some investors may ask for super pro-rata rights. That means that they want the right to be able to purchase more than their pro-rata ownership in the company when the company does another round of financing. 

I always tell my company clients that they should be wary of super pro-rata rights as it can limit the company from pursuing other investment options in the future. 

For example, some potential investors might not want to invest in the company unless they can purchase at least a certain percentage of the company. If some current investors have super pro-rata then potential investors may be cautious about investing.

C. Price-based anti-dilution protection

When investors talk about "anti-dilution protection," this is often what they are referring to. 

Price-based anti-dilution protection is a right that some investors have that keeps them from being diluted (to varying degrees) if stock is subsequently sold at a lower price per share than what the investor paid for it.

There are various formulas and mechanisms involved with price-based anti-dilution and correspondingly there is often room for negotiation for this. More on this below.
 

IV. PRICE-BASED ANTI-DILUTION BACKGROUND

A. Conceptual Example

You are the founder and sole stockholder. You have 100% of the company. Investor A comes in, buys in, and gets 33% of the company by purchasing stock from the company. You now own 67% of the company. Investor A has price-based anti-dilution protection. 

Investor B comes in, buys 25% of the company. 

Note that Investor B buys 25% of the company from the company, not from Investor A or from you. Investor B is buying from the company directly. This is normal. 

1. SUBSEQUENT INVESTOR BUYS AT THE SAME OR GREATER PRICE THAN THE PREVIOUS INVESTOR

If Investor B paid the same or greater price per share than what Investor A paid per share, then both you and Investor A will have less of the company than you had before. 

Price-based anti-dilution protection does not kick-in. Yes, you both get diluted, but the bright-side is that since people are paying more per unit, your share is more valuable than what it used to be. 

2. SUBSEQUENT INVESTOR BUYS AT A LOWER PRICE THAN THE PREVIOUS INVESTOR

If Investor B paid less than what Investor A paid per share, that's a signal that either the company is not worth as much as it was before or that Investor A's stock was improperly priced. 

In such a circumstance, price-based anti-dilution protection kicks in for Investor A. 

Remember, founders don't get anti-dilution protection. So only your ownership, as a founder, gets diluted to the full extent.  

Investor A does not have its ownership diluted (or only gets diluted a little bit.) How much exactly does Investor A get diluted? That all depends on what formula is used for dilution. More on that later. 

Investor A in essence overpaid for shares, and so Investor A must be compensated in some manner. How is Investor A compensated? 

Investor A does not get extra preferred stock distributed. What happens is that he gets more stock distributed to him when he converts his preferred stock to common stock.

B. Rationale behind price-based anti-dilution protection

The pricing of stock of a company and company valuations are not an exact science. In fact, believe me--I've seen it be complete bullshit. The rational behind price-based protection is that investors should be given a price adjustment if they overpaid for their shares and should therefore suffer less dilution. 

Theoretically the founders know much more about the company than the potential investors, so the investors get to have some protection for paying too much. 

Of course all investments carry risk. The investors made an investment and investors are well aware that investments can either go up or down. However, in some markets, particularly where investors have more bargaining power than founders, investors can have additional downside protection.
 

V. MECHANICS OF PRICE-BASED ANTI-DILUTION PROTECTION


As I mentioned, when a subsequent investor pays less for his shares, it's a sign that the previous investors overpaid for their shares. A company typically doesn't have a lot of cash to just give back to the investor, nor is it very practical to do this. 

What happens is that the investor receives a conversion price adjustment in order to compensate the investor. This comes into play when the investor converts preferred stock to common stock. 

Here's what that means. First, you need to know about conversion price.  

A. Background Concepts of Conversion Price
 

1. THERE ARE DIFFERENT KINDS OF OWNERSHIP STOCK IN A COMPANY

As you know, common stock is the basic unit of company ownership. This is what founders have. 

Investors receive preferred stock. This is stock in the company that comes with certain special rights and preferences over common stock. 

2. PREFERRED STOCK CAN CONVERT INTO COMMON STOCK AT A CERTAIN RATIO

Conversion timing can be done at the choice of the preferred stockholder. 

A preferred stockholder may want to convert his stock into common stock for a few reasons which I will not get into here. 

There are also times when preferred stock automatically converts into common stock, e.g., there is an initial public offering. 

There is a certain ratio at which preferred stock converts to common stock. Usually the way this is done is by dividing the initial purchase price of the preferred stock by something called the "conversion price." 

The conversion price fluctuates depending on certain events but it's typically originally set at the same value as the initial purchase price for a 1:1 ratio. So initially each share of preferred stock converts into one share of common stock.

The concept of conversion comes up in a number of scenarios. 

Voting and some other matters of the company are often calculated on an "as-converted-basis"

What does this mean? 

Person A has 1 share of common stock. Person B has 1 share of preferred stock. Person C has 1 share of a different kind of preferred stock. Assume that B's preferred share converts into more common shares than Person C's preferred share due to a more favorable conversion ratio. 

If there is a certain matter to be voted on, their voting power will be determined on an as-converted-basis. 

Person B will have more voting power than Person C. They will not need to convert their shares to common but it will be judged as if it were converted.

Thus, by using a adjusting the conversion price the company compensates a previous investor who paid more for their shares. The adjustment allows for more shares to be allocated to the investor at conversion.  
 

VI. DIFFERENT PRICE-BASED ANTI-DILUTION METHODS


An adjustment of the conversion price is done because it's impractical to return money to the investor or to issue more shares to him. So when the investor converts its preferred stock to common stock the investor will receive more common stock than it would have before. 

As mentioned, this is important even if the investor doesn't actually convert its stock because some matters of the corporation such as voting are calculated on an "as-converted basis."

But then the question remains--how much should the conversion price be adjusted?

For this there are different mathematical ways to calculate how much the investor should be compensated. Each method has its pluses and minuses for each party. Some methods account for how much stock the subsequent investor is purchasing. Other methods don't. Which method is selected depends on the negotiating power of the parties. 

A. RATIONALE BEHIND DIFFERENT PRICE BASED ADJUSTMENT METHODS

Why are there different price adjustment methods? Why not just say if there's a subsequent investor paying a lower price, then the conversion price adjustment will by x amount? 

This is because if the conversion price adjustment doesn't account for the size/price of the subsequent investment, then inequitable results will occur.  I'll explain with an example. 

1. EXAMPLE

Investor A pays $2.00 per share for a million preferred shares. Investor B then pays $0.01 per share and purchases just one preferred share. 

What Investor B bought and the price B paid is not really material and isn't a big deal. 

Should the conversion price and compensation to A for the million shares that A bought really be adjusted to correlate with the $0.01 that B paid for one preferred share?

No. 

The purchase of one share of stock compared to a million substantially affect anything?

So the adjustment needs to account at least a little bit for how much is being purchased. Because of this there are different methods to calculate the re-pricing to correlate with the size and price of the subsequent lower priced share purchase.

Below are the different kinds of possible methods used. 

B. FULL RATCHET METHOD

This is the simplest method but also deemed to be the most unfair. 

If an investor has full ratchet anti-dilution protection and there is any subsequent stock sold at a lower price than what the investor has paid for his stock, then the ratio is adjusted so that the investor would essentially get the same deal as the lower priced round of financing. 

The conversion price for the investor is lowered to match the purchase price of the new, lower priced financing. 

Full Ratchet is often not used and is considered unfair for a few reasons: 

(1) the dilutive, lower priced round investor ends up with less of the company than they wanted; 

(2) remember the earlier discussion about every time you dish out more pie, previous owners have less of it and are diluted? With full ratchet, most of the burden of dilution falls on the common stockholders; 

(3) the price adjustments are not rational and do not correlate with the size of the dilutive offering.

Later on in this article I will cover an example of full ratchet anti-dilution. 

C. WEIGHTED AVERAGE METHOD

This method is much more common than full ratchet. 

It uses the price and size of the later, lower priced round in adjusting the conversion ratio for the investor that has the anti-dilution protection. 

Some common variations are narrow-based weighted average and broad-based weighted average. These formulas vary on how the number of stock is counted. 

Out of full ratchet, narrow-based, and broad-based, full ratchet has the most severe effect on founders who do not have price-based anti-dilution protection. Broad-based has the least effect on founders. 

Founders would most like to see investors not have any price-based anti-dilution protection, but if the investors do get protection, then founders would like to see investors receive broad-based weighted average anti-dilution protection.
 

VII. PRICE-BASED ANTI-DILUTION FORMULAS

Now that you have an idea about the different methods used for price-based anti-dilution protection, here are the formulas used. In part VIII of this article I will go through some examples. 

A. Conversion Ratio

Conversion ratio is the ratio at which preferred stock converts into common.

It is the initial purchase price divided by conversion price. 

Conversion price is typically initially set to be the same as the initial purchase price so that preferred converts to common at a 1:1 ratio. 

Calculation of Number of Shares Formula: 

Number of shares of common issuable upon conversion = Number of preferred shares * (initial purchase price/conversion price) 

B. Full Ratchet

Formula:

Conversion price = purchase price per share of later, lower priced round

C. Broad-based weighted average

Formula:

New Conversion Price = Old Conversion Price * (Common Outstanding Pre Deal + What the Dilutive Round Should Have Bought if Not a Down Rounder) / (Common Outstanding Pre Deal + What the Dilutive Round Actually Bought)

D. Narrow-based weighted average

Same formula as part C above except a different mechanism is used to count the common outstanding. 

Formula:

New Conversion Price = Old Conversion Price * (Number of Shares of Series to Adjust + What the Dilutive Round Should Have Bought if Not a Down Rounder) / (Number of Shares of Series to Adjust + What the Dilutive Round Actually Bought)

VIII. PRICE-BASED ANTI-DILUTION EXAMPLES

A. Scenario

Common Stock: 2,000,000

Series A Preferred Stock: 3,000,000 issued at $1.00 per share

Total: 5,000,000 shares of stock (Common outstanding (as-converted basis)) 

Series B Investor then comes in and for $1,875,000 purchases 2,500,000 preferred shares for $0.75 per share. 

Because Series B Investor paid less per share than Series A Investor, this is considered a dilutive round of financing and the Series A Investor will receive a price adjustment when it converts to common stock. The new conversion price for Series A and the amount of shares of common issuable upon conversion are as follows. 

1. FULL RATCHET

Full ratchet formula:

Conversion price = purchase price per share of later, lower priced round

Conversion price = $0.75

Calculation of number of shares formula:

Number of shares of common issuable upon conversion = Number of preferred shares * (initial purchase price/conversion price)

Number of shares of common issuable upon conversion = 3,000,000 * (1.00/0.75) 

Number of shares of common issuable upon conversion = 4,000,000

4,000,000 shares of common will be issuable to the Series A investor when the Series A investor converts the 3,000,000 Series A preferred shares under the full ratchet formula.

2. BROAD-BASED WEIGHTED AVERAGE

Broad-based weighted average formula:

New Conversion Price = Old Conversion Price * (Common Outstanding Pre Deal + What the Dilutive Round Should Have Bought if Not a Down Round) / (Common Outstanding Pre Deal + What the Dilutive Round Actually Bought) 

New Conversion Price = 1.00 * (5,000,000 + 1,875,000) / (5,000,000 + 2,500,000)

[Note: Recall that Series B investor spent $1,875,000. If it weren't a down round--meaning if Series B paid the same price as Series A of $1.00, then Series B would have bought 1,875,000 shares. Instead, Series B investor was able to purchase 2,500,000 shares.] 

New Conversion Price = 0.917

Calculation of number of shares formula:

Number of shares of common issuable upon conversion = Number of preferred shares * (initial purchase price/conversion price) 

Number of shares of common issuable upon conversion = 3,000,000 * (1/0.917) 

Number of shares of common issuable upon conversion = 3,271,538

3,271,538 shares of common will be issuable to the Series A investor upon conversion of the 3,000,000 Series A preferred shares under the broad-based formula. 

3. NARROW-BASED WEIGHTED AVERAGE

Narrow-based weighted average formula:

New Conversion Price = Old Conversion Price * (Number of Shares of Series to Adjust + What the Dilutive Round Should Have Bought if Not a Down Rounder) / (Number of Shares of Series to Adjust + What the Dilutive Round Actually Bought) 

New Conversion Price = 1.00 * (3,000,000 + 1,875,000) / (3,000,000 + 2,500,000) 

New Conversion Price = 0.886

Calculation of number of shares formula:

Number of shares of common issuable upon conversion = Number of preferred shares * (initial purchase price/conversion price) 

Number of shares of common issuable upon conversion = 3,000,000 * (1.00 / 0.886) 

Number of shares of common issuable upon conversion = 3,386,005. 

3,386,005 shares of common will be issuable to the Series A investor upon conversion of the 3,000,000 Series A preferred shares under the narrow-based formula.

B. Takeaways from examples

- Notice that the most shares issued on conversion to Series A investor was in the full ratchet example. This is why full ratchet is generally considered harsh or unfair to founders and common stock holders

- The least amount of shares issued on conversion was in the broad-based example. Broad-based is generally most favorable for the founders and common stock holders

IX. EXCEPTIONS AND CARVE-OUTS

A quick note on this.

There will be instances where investors should not receive a conversion price adjustment even though there is a future issuance of shares at a lower price. 

Recall that one rationale for price based anti-dilution is to correct a pricing mistake. There are times when shares for a lower price must be issued for reasons that are not related to a pricing mistake or similar.

These exceptions are carveouts such as shares issued for employee options, shares issued in a loan or debt financing arrangement, and shares where a majority of the preferred shareholders waive their anti-dilution rights.
 

X. ACCOMPANYING ANTI-DILUTION PROVISIONS WITH PAY-TO-PLAY PROVISIONS

Pay-to-play provisions often accompany anti-dilution provisions and I want to highlight them here so that you know what they are when you see them.  

Pay-to-Play provisions are clauses in a financing agreement that dictate that an investor must either invest on a pro-rata basis in a future financing or have their rights stripped from them. 

The logic behind such a clause is that the company wants to give incentive that investors should be in it for the long haul. The company wants the investors to give support even if the company isn't doing too well and has to have a down round of financing. You DON'T want a situation where previous investors can just sit back and get price-adjustments. 

Having their rights stripped away means either having their preferred shares convert into a different type of preferred shares which have less rights (e.g. no anti-dilution rights) or it means having their preferred shares convert into common shares. 

So there are a variety of pay-to-play provisions and some are more punitive than others. The severity depends on the relative negotiating powers of the parties. 
 

XI. TAKEAWAYS AND SUMMARY OF WHAT IS DILUTION

A. Dilution means that your ownership percentage of the company is lowered.

B. Dilution happens to existing stockholders whenever the company issues stock to others. This occurs to existing stockholders when the company does an equity financing and brings on investors. 

C. Investors and preferred stockholders receive anti-dilution protection to protect themselves from excessive dilution. Founders and common stockholders don't receive this. 

D. There are different types of anti-dilution protection. The one commonly addressed is price-based anti-dilution protection. 

E. Price-based anti-dilution protection kicks in for existing investors when subsequent investors buy stock for a lower price than what the existing investors paid for it. 

F. There are different formulas for price-based anti-dilution protection that offer more or less protection for investors. 

G. The full ratchet formula is tough on founders and common stockholders. Broad-based is more lenient on founders and common stockholders and is what founders should negotiate for in an equity financing. 
 

XII. TIPS FOR FOUNDERS REGARDING DILUTION

1. Never give absolute non-dilution protection. That is where an investor demands to have a certain, fixed percentage of the company no matter how many future investors are brought into the company. 

2. Don't allow for full-ratchet protection. Weighted average is more common and is generally accepted as more fair. Narrow-based weighted average is more favorable to investors. Broad-based weighted average is more favorable to founders. 

3. Be cautious about giving anti-dilution protection to an investor who is unable to invest much more capital into the company going forward. 

4. Make sure there are proper carveouts. Certain small issuances of stock at low prices should not trigger anti-dilution protection. 

5. Consider accompanying pay-to-play clauses with anti-dilution provisions. 

6. Avoid the milestone approach where certain conversion price adjustments are made if the company doesn't meet certain financial goals. Goals and the direction of the company change over time. Also, different accounting standards can change financial numbers. It's just messy. 

7. Try to have the right valuation of your company. The valuation of the company is what the investment share price of the company is based off of. Valuating an early-stage company is a difficult thing and is an in-exact science, but it can be worth the effort to get it "right." 

8. Pay attention to minority shareholder and voting rights and provisions. 

9. Remember that dilution is not necessarily a bad thing and can be the sign of good things happening to your company. 

10. Don't give out super pro-rata/super preemptive rights.  

11. Watch how much equity your company is dishing out. That's the best way to control dilution.

12. Pay attention to other matters and relations between founders, managers, investors. Bringing on more investors doesn't just affect financial and ownership dilution but it also affects matters like voting power and control of the company.