F317 – Venture Capital & Entrepreneurial Finance Anti-Dilution and the Cramdown

Investors expect dilution to occur post investment. It’s a natural part of the process. However, what they don’t want to see is their % ownership diluted as well as the value of their ownership decrease in addition (price-based dilution) 10,000 FT View

Dilution Definition: Ownership % of existing shareholders decreases in proportion to the percent of the company the new investor purchases. % Ownership Time Time of Investment After more investors purchase equity

Good Dilution However, the goal is for the value of your ownership to increase even though the % Ownership is decreasing due to subsequent raises % Ownership Value of Ownership Point of Investment At Exit

Notwithstanding “Good Dilution”, smart Investors will want the ability to maintain their ownership percentage when a company is “crushing” it (i.e. Instagram, Facebook, etc.) The provision is called Pre-emptive Rights Anti-Dilution Provisions

Enables the Investor to maintain its percentage ownership in the company by purchasing a pro rata share of stock sold in future financing rounds. Pre-emptive Rights

Ex. VC owns 1,000,000 shares (or 10% of shares) of YellowBox Software. The Board decides to raise additional money by issuing an additional million $30 per share. If VC wants maintain its 10% ownership, it will have to purchase 100,000 shares in the round at $30 per share. ($3MM Investment).

What’s the challenge of Pre-emptive rights?? For an investor to exercise Pre-emptive rights, it has to have the cash to invest in subsequent rounds and at higher dollar amounts. Pre-emptive Rights

Bad Dilution – The Cram Down A Cram Down is when the a Company raises capital at a share price lower than what previous investors paid.

“Cram-Down” Ex. Bob makes an investment of $1MM into TerraData. He paid $1 Per Share and received 10% of the Company. Two years later, Sara makes an investment of $3MM at $.60 Per share. Here’s the impact on Bob’s Investment: Ownership % >6.67% (from 10%) Value of Equity>$600,000 (from $1MM)

“Cram-Down” Cram-Downs occur when: A company is in desperate need of capital and investor options are limited; “or” The risk profile of the deal is higher than when previous investors came in “or” The earlier investor(s) simply mispriced the investment (i.e. assigned too high of a valuation)

“Cram-Down” Regardless of the reason, Sophisticated Investors want to take steps to protect themselves from the worst part of Cram-Downs – The devaluing of their equity in a subsequent round. Thus, it’s common to see a “Price-Based” Anti- Dilution provision in an Investment Agreement.

Price-Based Anti-Dilution Provisions Type 1 – Full Ratchet Anti-Dilution An investor with Full Ratchet protection receives the ability to have her investment “re- priced” at the same valuation as the new investor….she is compensated by receiving additional shares to fully restore the value she lost as a result of the Cram-Down.

Price-Based Anti-Dilution Provisions Type 1 – Full Ratchet Anti-Dilution (Previous Example) Bob makes an investment of $1MM into TerraData. He paid $1 Per Share and received 10% of the Company. Two years later, Sara makes an investment of $3MM at $.60 Per share. Let’s see what happens of Bob has Full-Ratchet Anti-Dilution.

Price-Based Anti-Dilution Provisions Type 1 – Full Ratchet Anti-Dilution FoundersBobSara # Shares9,000,0001,000,0005,000,000 $ Per Share Paid$1$.60 Total Shares Outstanding10,000,00015,000,000 Before Anti-Dilution Provision is Triggered

Price-Based Anti-Dilution Provisions Type 1 – Full Ratchet Anti-Dilution If Bob has “Full Ratchet” Anti-Dilution protection: Formula: Bob investment gets re-priced as if he had purchased shares at $.60 (as opposed to the $1.00 price point). i.e. $1,000,000 / $.60 = 1,666,667

Price-Based Anti-Dilution Provisions Type 1 – Full Ratchet Anti-Dilution FoundersBobSara # Shares9,000,0001,000,0005,000,000 Price Per Share Paid$1 $.60$.60 Additional Shares issued to Bob667,667 Shares Owned Post Cram-Down1,667,6675,000,000

Price-Based Anti-Dilution Provisions Type 1 – Full Ratchet Anti-Dilution Thus, by triggering the Anti-dilution provision, Bob now owns 1,666,667 the new price of $.60 per share. This ensures that the value of Bob’s investment remains at $1MM, despite the Cram- Down by Sara.

Price-Based Anti-Dilution Provisions Type 2 – Weighted Average Anti-Dilution An investor with Weighted Average protection receives the ability to have her investment “re- priced” at a Weighted Average price (based on previous investment and current investment). Note: Unlike Full-Ratchet, Weighted Average does not provide for Full Price Protection

Price-Based Anti-Dilution Provisions Type 2 – Weighted Average Anti-Dilution Here’s the Formula Diluted Investor RoundInvestmentShares Received Subsequent RoundInvestmentShares Received Combined Investment (CI) Combined Shares (CS) Weighted Average Share Price (CI / CS) $

Price-Based Anti-Dilution Provisions Type 2 – Weighted Average Anti-Dilution Ex. Bob & Sara Bob$1,000,0001,000,000 Sara$3,000,0005,000,000 $4,000,0006,000,000 Weighted Average Share Price (CI / CS) $.67

Price-Based Anti-Dilution Provisions Type 2 – Weighted Average Anti-Dilution If Bob has “Weighted Average” Anti-Dilution protection: Formula: Bob investment gets re-priced as if he had purchased shares at $.67 (as opposed to the $1.00 price point). i.e. $1,000,000 / $.67 = 1,492,537

Price-Based Anti-Dilution Provisions FoundersBobSara # Shares9,000,0001,000,0005,000,000 Price Per Share Paid$1 $.67$.60 Additional Shares issued to Bob492,537 Shares Owned Post Cram-Down1,492,5375,000,000 Type 2 – Weighted Average Anti-Dilution

Price-Based Anti-Dilution Provisions Type 2 – Weighted Average Anti-Dilution Thus, by triggering the Anti-dilution provision, Bob now owns 1,492,537 the new price of $.60 per share (as determined by Sara’s investment). The value of Bob’s investment will be $895,522, after the Cram-Down. Again, this is not full-price protection.

Price-Based Anti-Dilution Provisions Neither Anti-Dilution provision is Founder Friendly, but, between the two, Full-Ratchet is worse. Remember, no new cash is coming in because of a triggering….it’s just a “re-pricing” of an earlier round that benefits the investor……and….. New investors are not going to be diluted by the triggering of an Anti-Dilution provision….the Founders (and perhaps Family & Friends) that bear the brunt of the dilution.

End of Lecture Ready for the Team Exercise?

Anti-Dilution Team Exercise / F317 (Page 19 in TVG Game Book) EXERCISE ASSUMPTIONS Founder Shares3,500,000 Angel Shares500,000 Series AInvestment$2,500,000 Post-Money$11,300,000 Series BInvestment$4,500,000 Price Per Share$1.12

Anti-Dilution Team Exercise / F317 (Page 19 in TVG Game Book) Investment$2,500,000 Post-Money$11,300,000 Equity New Shares1,136,364 Series A Investor 4,000, ,000,000 ( )

Anti-Dilution Team Exercise / F317 (Answer) Series BSeries AAngelsFounders Investment$4,500,000$2,500,000 PPS$1.12$2.20 Founders 3,500, % Angels 500, % Series A 1,136, % Series B4,017, % Total4,017,8571,136,364500,0003,500,000 9,154,221 Before Anti-Dilution Provision is Triggered

Anti-Dilution Team Exercise / F317 (Answer) FULL RATCHET ANTI-DILUTION Investment$2,500,000 New Price$1.12 Total Shares2,232,143 New Shares1,095,779

Anti-Dilution Team Exercise / F317 (Answer) WEIGHTED AVERAGE ANTI-DILUTION InvestmentShares Series A$2,500,0001,136,364 Series B$4,500,0004,017,857 Combined$7,000,0005,154,221 Weighted Average Price$1.36 Investment$2,500,000 New Price$1.36 Total Shares1,840,793 New Shares704,429

Any Questions?