Weighted Average Dilution
The most common anti-dilution protection is called “weighted-average,” anti-dilution protection. This approach employs a formula to adjust the rate at which preferred stock converts into common stock based upon:
- the amount of money previously raised by the company,
- the price per share at which it was raised,
- the amount of money being raised by the company in the subsequent dilutive financing, and
- the price per share at which such new money is being raised.
The weighted-average price (which will always be lower than the original purchase price following a dilutive financing) is then divided into the original purchase price in order to determine the number of shares of common stock into which each share of preferred stock is then convertible. This formula derives a new, reduced conversion price for the preferred stock. The result is an increased conversion ratio for the preferred stock. If new stock is issued at a price per share lower than the current conversion price for a particular series of preferred stock (a down round), the conversion price of the preferred series will be calculated by the following formula:
AP = OP x (CO + NCE) / (CO + CE)
AP = New or Adjusted Conversion Price
OP = Original Conversion Price of Preferred Shares
CO = Common stock Outstanding Pre-deal
CE = Value of Common Equivalent of Preferred Shared
NCE = Value of Common Equivalent in the New Issuance
Company A has 100 common shares and issues 100 preferred shares in a Series A financing at $1.00. As discussed in previous lectures, the preferred price matches the common stock price at the time, so the conversion ratio is 1:1 at the time. In a series B round the company issues 100 shares at $.50. The weighted-average, anti-dilution provision would offer protection to the series A preferred shareholders by adjusting the conversion price (the AP). To calculation the AP, let’s plug in the above formula.
OP = The original conversion price was $1.00
CO = The common outstanding in the simple scenario equals 100.
CE = The common equivalent of the preferred shares is the $100 (100 x $1)
NCE = The common equivalent of the preferred shares is $50 (100 x $.5)
AP = $1.00 x (100 + 50 / 100 +100) = $.75