Weighted average anti-dilution

When a down round fires an anti-dilution clause, somebody has to decide what the preference shares now convert at. There are two answers.

Full ratchet resets the conversion price all the way down to the new, lowest issue price. It restores the investor completely and hits the founders hardest.

Weighted average resets it to a blend — the total money the company has ever raised divided by the total shares it has ever issued. Because the earlier, higher-priced rounds are still in that average, the new conversion price lands between the old price and the down-round price. The investor gets extra shares, but not as many.

The workbook puts it in one line: the full ratchet method will always be more beneficial to owners of preferred shares, while the weighted average method helps protect some of the value.

The mechanics are two divisions and a multiplication.

First, the new conversion price: the ratio of the total consideration received from all issues to the total number of shares issued till date. Second, the revised conversion ratio: the old conversion price divided by the new one, which is the multiplier applied to the equity the preference holder was previously entitled to.

Anti-dilution rights of this kind are typically attached to convertible preference shares, and sit alongside the related pre-emptive right — the right, but not the obligation, to participate pro rata in future issues and stock option exercises so as to hold percentage ownership steady.

The context is why venture deals bother. The workbook's framing is that in early-stage investments the investor looks for downside protection first and returns later, and the main risk being protected against is over-valuation, because the valuation model rests mostly on future growth parameters. Hence the ratchet is addressed more stringently in venture deals than elsewhere.

New conversion price  = Total consideration received from all issues
                        ÷ Total number of shares issued till date

Revised conversion    = Old conversion price ÷ New conversion price
multiplier

Revised equity shares = Original equity entitlement × multiplier

The workbook's worked example, Chapter 10.

Start-up XYZ has 1,00,000 equity shares at Rs 10 each. It raises angel funding by issuing 30,000 preference shares at Rs 10 each, convertible in the ratio 1:2 at a conversion price of Rs 20 per equity share — so 15,000 equity shares on conversion. The angels hold anti-dilution rights. The company later raises a pre-Series A by issuing 25,000 shares at Rs 10 each, below the Rs 20 conversion price. The clause fires.

Under full ratchet, the conversion price drops to the lowest issue price of Rs 10, and the angels convert into 30,000 equity shares instead of 15,000 — an extra 15,000 shares.

Under weighted average:

So 1.79 equity shares are issued in place of each 1 the angels were previously entitled to: about 26,850 shares against the 15,000 they started with, and against the 30,000 a full ratchet would have delivered.

Weighted average gave the angels about 79 per cent of the repair — 11,850 extra shares against the 15,000 a full ratchet would have produced. The 3,150-share difference, roughly 2 per cent of the company, is what the founders kept by negotiating the method into the term sheet.

Chapter 10 (Investment Process and Governance of Funds), section 10.4.3 on anti-dilution rights, with this exact example. Expect to be handed the three capital raises and asked for the new conversion price, or for the revised conversion ratio; and a comparison question on which method favours the preference holder — always full ratchet.

• The workbook's denominator does not match its numerator. The Rs 14,50,000 of consideration includes the Rs 1,50,000 raised from the pre-Series A investors, but the 1,30,000 share count is the 1,00,000 equity plus 30,000 preference shares only, without those 25,000 new shares. Recomputing from first principles on 1,55,000 shares gives Rs 9.35 and a multiplier of 2.14. Answer with the workbook's Rs 11.15 and 1.79 — that is what the paper is set from — but know why your own arithmetic disagrees.
• Full ratchet is always better for the investor. A question asking which method is more favourable to preference holders is never answered "weighted average".
• The multiplier is old price ÷ new price, not new ÷ old. Getting it upside down produces fewer shares, not more.
• The ratio "1:2 at Rs 20" in the example means the Rs 3,00,000 of preference capital converts into 15,000 equity shares — two preference shares per equity share.
• Anti-dilution and pre-emption are different rights. Pre-emption keeps your percentage by letting you buy more; anti-dilution repairs your conversion price when somebody else buys cheaper.
• Full ratchets are complicated to operate and raise tax and regulatory issues, which is the workbook's stated reason they need careful thought — not that they are unenforceable.