The spread of COVID-19 has undeniably driven the accelerated adoption of fintech solutions across Southeast Asia and leading fintech start-ups have in recent times found themselves to be in a good position to raise more capital. However, the harsher reality of the pandemic and the economic turmoil has in fact had a significant adverse impact on equity values and valuations of companies across the world, including Southeast Asia.
Start-ups looking to raise capital by across multiple rounds of fund raising may not be able to do so in the usual fashion where each subsequent round is closed at a higher price per share than the last. The spectre of “down rounds” or the issuance of shares at lower prices than previous rounds, is now an increasing reality.
For companies that have issued earlier rounds of convertible preferred equity, a down round is likely to result in the application of anti-dilution mechanisms attached to such preceding preferred equity.
This briefing will look into some anti-dilution mechanisms commonly adopted in convertible preferred equity, highlight the issues that both investors and issuers need to keep in mind when negotiating these provisions and briefly touch on possible alternatives to a down round.
There are three common types of anti-dilution protection mechanisms used in convertible preferred equity. They are:
- Full ratchet adjustment;
- Broad-based weighted average adjustment; and
- Narrow-based weighted average adjustment
Full ratchet adjustment
From the perspective of holders of convertible preferred equity, the full ratchet adjustment mechanism is the most preferred. It disregards the size of the dilutive down round and the conversion rate is adjusted such that the holder of the convertible preferred equity may convert into such number of ordinary shares equal to their original investment divided by the price per share of the down round. In essence, the existing investor gets the benefit of the new, lower per share price.
For the holders of ordinary shares, in particular the founders, this mechanism is the most draconian (or extreme) as it results in a disproportionate dilution of their stakes in the company.
As such, full ratchet mechanisms are seldom used or agreed to in the vast majority of venture capital deals.
Broad-based weighted average adjustment
Based on our experience, the broad-based weighted average mechanism is the most commonly adopted mechanism.
The broad-based weighted average mechanism reduces the conversion price of existing convertible preferred equity based on the number of shares and subscription amount raised in the down round.
Taking the formula used in the Venture Capital Investment Model Agreement (VIMA) Model Subscription Agreement, the following is an example of a formula for a broad-based weighted average mechanism:
Note that “A”, or the “Number of Ordinary Shares outstanding immediately prior to the new issue”, is calculated on “a fully diluted, as converted basis”, which typically includes shares reserved for issuance under stock option plans and issuable pursuant to the exercise of outstanding warrants and other convertible securities of the company.
By increasing the number of outstanding ordinary shares in this manner, the magnitude of a dilutive issue (and the resulting anti-dilution adjustment) is reduced.
As such, the holders of ordinary shares or the founders, would be keen to include as many shares as possible in calculating “A” i.e. the number of ordinary shares outstanding prior to the down round.
Conversely, would-be investors of convertible preferred equity would prefer to include as few shares as possible. This divergence of interests then dovetails into the other form of weighted average mechanism: the narrow-based weighted average adjustment.
Narrow-based weighted average adjustment
For a narrow-based weighted average mechanism, the formula used would be near identical to that set out above for the broad-based weighted average mechanism, with the only difference being “A”, which would be defined more narrowly:
Given the narrower definition of “A”, the narrow-based weighted average formula provides a greater number of additional shares of ordinary shares to be issued to the holders of convertible preferred equity upon conversion than under the broad-based formula.
As one would expect, how “A” is defined is often an area of negotiation between the founders and investors when discussing which of the weighted-average formulas to use. Parties may end up agreeing on a middle ground “in-between”.
Pros and cons: which mechanism?
As alluded to earlier, the broad-based weighted average mechanism is the most commonly adopted mechanism in the majority of venture capital deals. And rightly so.
The shareholders who are impacted the most in any anti-dilution mechanism would be the founders. An extreme anti-dilution mechanism such as the full ratchet mechanism will invariably skew shareholder incentives and hence complicate any down-round fund raise. The founders will have a strong incentive to limit such down rounds to minimise the dilution to their shareholding, even when the company is most in need of funds. This would not be to the advantage of anyone who is vested in the company.
Additionally, extreme anti-dilution mechanisms can complicate fund raising efforts of the company. Incoming investors might insist on the same rights or, worse still, require the investors from such previous rounds to consent to have their rights weakened as a pre-condition to their investment.
It is therefore clear that a weighted-average mechanism represents a fair and balanced tool that addresses both the investors and founders’ interests.
What else apart from anti-dilution mechanisms?
Raising funds via a down round that triggers anti-dilution adjustments is not the only option for companies that are not able to support their prior valuations, whether due to the effects of the COVID-19 pandemic or otherwise.
Sometimes, a company just needs a short term cash injection to ride out a rough patch and get back on track. One alternative to a down round may, therefore, be to do a convertible note financing whereby the notes convert into the preferred equity at the next round of fund raising, usually at a discount to the price per share of such round.
Another alternative would be for the founders to negotiate with the holders of the convertible preferred equity. It may be worth the founders’ time to discuss with such holders the possibility of waiving or partially reducing anti-dilution adjustments, keeping in mind that terms that have been agreed in a prior financing round does not mean that such terms cannot be renegotiated in connection with the next round. If approached by founders, holders of convertible preferred equity should remember, when engaging in such discussions, that management i.e. the founders, need to be incentivized by their post-down round shareholding to remain committed to the business.
There are various anti-dilution options that companies and investors can use in a potential down round situation. It would be imperative for parties to recognise the implications of each of these options, or even to consider alternatives to a down round.