Anti-Dilution – Balancing the ills of a Down Round

Any investment by a Venture Capital (‘VC’) or Private Equity (‘PE’) investor is made with the hope of seeing sizeable returns as the business of the investee company grows over years. However, if the situation turns, a decreased valuation will reduce worth of the VC or PE investor’s stake in the company, resulting in significant loss to the investor. 

A steep decline in valuation can result from a multitude of reasons that range from stagnant growth of business and revenues to governance issues, to increased costs of debt and repayment obligations, to a dwindling reputation of company or its management.

Anti-dilution rights are the most common armour provided to investors against a down round funding raised by any company. These can be exercised in two ways - the first being full ratchet anti-dilution protection while the second is weighted average method of computation.

Full Ratchet Protection:

A full ratchet anti-dilution right provides absolute protection to an investor by revaluing their original investment at the price offered by the company in such down round and accordingly increasing the number of shares that they hold in the company on a fully diluted basis.

Let us assume that an investor invests in a total amount of USD 1,000,000 in a company for 1000 convertible preference shares at the price of USD 1000 per share and negotiates a full ratchet price protection right. If, in a subsequent down round, the said company issues its shares at the lower price of USD 500 per share, it will be assumed that the original investment was made at this reduced price, and the original investor in question will be entitled to further 1000 shares in the Company.

While most advantageous to any investor, full ratchet right is also the most uncommon in general practice, purely because of being unfair to the promoters. It does ensure ‘non-dilution’ of the investor’s interests and that they do not bear the brunt of a down round to any extent. However, it does so by causing inordinate dilution in the shareholding of promoters and other shareholders who may have not negotiated this right. A dilution of this character can lead to loss of control of the promoters over the company, with an external investor getting a majority of the shareholding. Successive down round investments coupled with a full ratchet anti-dilution right will invariably lead to transfer of a lion’s share of ownership to new investors, making the company unappealing to other existing and prospective shareholders.

Weighted Average Protection:

A weighted average right follows a more equitable approach, taking into consideration both the price at which shares were initially issued to an investor and the price at which shares are being issued in the down round.

A weighted average right can either be broad-based or narrow-based. Broad-based computation takes into account all shares of the company on a fully diluted basis, meaning that all options, warrants or other convertible securities are deemed to have been converted into shares at the time of determination. In case of a narrow-based determination, as the name suggests, a narrower approach is taken with only those shares being considered that have actually been issued and allotted, while any unexercised options or warrants are disregarded.

The formula used for weighted average anti-dilution protection is:

NCP = OCP * (A+B) / (A+C) 

where,

NCP is the new conversion price,

OCP is the original agreed conversion price,

A is the total number of shares immediately prior to the down round,

B is the number of shares that would have been issued in the new round had it been raised at the valuation of the original round; and

C is the number of shares being issued in the down round.

Let us assume that: (i) an investor (‘Investor 1’) has invested USD 1,000,000 in a company and is allotted 1000 convertible preference shares at the price of USD 1000 per share, with a conversion price of USD 1000, and (ii) after the investment, the cap-table of the company, on a fully diluted basis, is as follows:

Thereafter, in a subsequent down round, a new investor (‘Investor 2’) also invests USD 1,000,000 and is allotted 2000 shares at a lesser price per share of USD 500. The cap-table of the company (on a fully diluted basis) without any anti-dilution protection to Investor 1 will be as below:

If, however, Investor 1 has weighted average anti-dilution protection, a new conversion price will be computed for the convertible preference shares held by it. The computation (basis the above formula) will be as follows:

OCP = USD 1000

A = 10000

B = 1000

C = 2000

NCP = 1000 * (10000+1000)/(10000+2000) = 916.7

In this instance, Investor 1 will be entitled to convert its convertible preference shares at the new conversion price and acquire a few additional shares. The number of additional shares to be allotted to it will be:

USD 1,000,000 / USD 916.7 = 1,091

The cap-table of the company on a fully diluted basis, in light of the new conversion price will be:

As is evident from above, with weighted average anti-dilution right, the magnitude a down round’s impact on Investor 1 will reduce, without causing excessive dilution in shareholding of promoters and other shareholders.

Implementation of Anti-Dilution Rights:

The customary way of enforcing an anti-dilution right is adjustment of conversion price and issue of additional shares accordingly.

The single largest hurdle in this implementation may occur due to the pricing guidelines set forth in the Foreign Exchange Management (Non-Debt) Instruments Rules, 2019 (‘NDI Rules’).

These rules require that issue of shares of a private limited company to a non-resident shareholder cannot be at a price less than fair market value determined as per any internationally accepted pricing methodology for valuation on an arm’s length basis duly certified by a chartered accountant or a merchant banker registered with the Securities and Exchange Board of India or a practising cost accountant. Further, as per Rule 21 of the NDI Rules, conversion of any convertible equity instrument must not be at a price less than the fair market value determined at the time of issue of such instruments (as stated above).

The above requirement makes it impossible to issue shares free of cost to any non-resident investor in exercise of their anti-dilution right. Similarly, exercising an adjusted conversion price which is less than the fair market value at the time of issue of equity instruments is also prohibited.

To address this concern, it is suggested that the issue price of equity instruments for any non-resident investor be over and above the fair market value determined in compliance with the pricing guidelines. This will ensure that there exists a cushion between issue price and fair market value that can absorb any downward adjustment of conversion price.

Another way out can be primary issue or secondary transfer of shares by founders to a resident nominee of the non-resident investor at minimum permissible prices, who will hold the shares and exercise its rights over them as per instructions of the concerned foreign investor. This, however, will be useful only if the non-resident investor can identify such a nominee resident in India.

Conclusion

Anti-dilution rights are critical for creating an investor’s confidence in the company where it intends to make investment. At the same time, anti-dilution rights should not be structured in a way that protects interest of a single investor at the cost of interest held by founders or other shareholders in the Company. An unbalanced right will demotivate existing shareholders as well as become a handicap in future rounds of investment. Company and promoters may, with respect to the same, negotiate a pay-for-play provision that entitle an investor to ant-dilution rights so long as they continue to participate in future rounds of funding raised by the Company. Alternatively, a sunset provision may be agreed to, with anti-dilution rights being provided only for first few rounds of investment and once the company has reached a pre-agreed valuation threshold, the right can cease to be of any effect.

Negotiations of anti-dilution clauses must consider all intricacies, advantages and limitations of the concept. Impact of all subtle changes introduced in the clause should also be analysed by the parties. A comprehensive understanding of the provision and a methodical clause drafted accordingly will ensure that in an event of a down-round, interests of investors remain protected, do not become burdensome to the promoters or other shareholders and are enforced without any unwarranted complications.  

[The author is a Principal Associate in Corporate and M&A practice at Lakshmikumaran & Sridharan Attorneys, Hyderabad]