Antidilution Clause

Antidilution Clause

Investors in a venture company are required to convert the issued preferred class shares into common shares when the company goes public. In most cases, the conversion ratio is calculated according to the following formula.

Conversion ratio = paid-in amount per share of class shares / Conversion Price

In the case of Class A preferred shares issued at 50,000 yen per share, the conversion ratio at the time of those issuance is 50,000/50,000 = 1 (i.e., 1 share of Class A preferred share is exchanged for 1 share of common share). In the event of a share split or reverse share split, etc., an adjustment formula will be established to adjust the value by the same ratio, so the ratio of 1:1 will basically be secured.

On the other hand, if the paid-in amount per share in the next round of financing is less than the previous round (so called, “down-round”), the conversion ratio must be adjusted, or it would be unfair to investors who invested before hand.

Sample Case:

Conclusion: Without the anti-dilution clause, shareholders A and B will both receive 5,000 shares of common shares, which will be unfair to shareholder A as shareholder B, who has invested only half the amount, will receive the same equity ratio as A does.

In order to prepare for such a down-round financing, an anti-dilution provision needs to be stipulated in advance.
There are three main types of anti-dilution clauses which are (i) Narrow-Based Weighted Average (ii) Broad-Based Weighted Average, and (iii) Full ratchet

Narrow-Based Weighted Average

The Narrow-Based Weighted Average is an anti-dilution provision calculating the Conversion Price by using the following formula.

Conversion Price After Adjustment = ((Number of shares issued × Conversion Price before adjustment) + (Number of newly issued shares × Paid-in amount per share))/(Number of shares issued + Number of newly issued shares)

Sample Case:
Calculate the Class A conversion ratio assuming that the Class B preferred shares are issued in a down-round as the chart above.

Class A Conversion Price After Adjustment:
((15,000×50,000)＋(5,000×25000))/( 15,000＋5,000)＝43,750

Therefore, Adjusted Class A conversion ratio:
50,000／43,750＝1.14

As described above, 1.14 shares of common share will be delivered per Class A preferred share; thus, Shareholder A will receive 5,714 shares of common shares for 5,000 shares of Class A preferred share.

Broad-Based Weighted Average

The Broad-Based Weighted Average is an anti-dilution provision which includes numbers of potential shares such as share acquisition rights to the “number of shares issued” in the Narrow-Based Weighted Average’s formula above. However, since the exercise price of SOs granted to officers and employees is usually less than the amount paid for the class of shares, such potential shares are usually excluded from the anti-dilution provisions. (In such cases, a maximum limit is specified as “excluding the issuance of SOs equivalent to XX% of the number of existing shares”.)

Sample Case:
Calculate the Class A conversion ratio assuming that the Class B preferred shares are issued in a down-round as the chart above, and issuing share acquisition rights in between them.

Class A Conversion Price After Adjustment:
((20,000×50,000)＋(5,000×25000))/( 20,000＋5,000)＝45,000

Therefore, Adjusted Class A conversion ratio:
50,000／45,000＝1.11

As described above, 1.11shares of common share will be delivered per Class A preferred share; thus, Shareholder A will receive 5,555 shares of common shares for 5,000 shares of Class A preferred shares.

Full Ratchet

A Full Ratchet is an anti-dilution provision, which directly replaces the lowered paid-in amount per share to be the Class A conversion price.

Sample Case:
Calculate the Class A conversion ratio assuming that the Class B preferred shares are issued in a down-round as the chart above.

Adjusted Class A conversion ratio:
50,000 / 25,000 = 2

As described above, 2 shares of common share will be delivered per Class A preferred share; thus, Shareholder A will receive 10,000 shares of common shares for 5,000 shares of Class A preferred share.

As above, an anti-dilution provision will be advantageous in the order of full ratchet > narrow-based weighted average > broad-based weighted average to investors and disadvantageous to founding shareholders.

MK @ 11/23/2022