Dilution and Anti-dilution Hoje Jo Santa Clara University

Dilution and Anti-dilution Suppose NewCo. issue: 1 mil. Common stock  founders own all common stock (c/s) 1 mil. convertible p/s  investors (VCs) own all convertible preferred stock (cp/s)

Case A: Suppose Newco desperately needs $25,000 cash. So, the firm issues 50,000 shares of c/s at $0.5/share

Full Ratchet: Before Founder: 1m/2m = 50% VC: 1m/2m = 50% New investor’s position 0

Full Ratchet: After New shares = 50,000 From convertible preferred stock, VC can convert into 2 mil. Shares of common stock (=1 mil./$0.5) founder’s equity Position: 1m/(1m+2m+50,000)  32.79% VC’s equity Position: 2m/(1m+2m+50,000)  65.57% New investor’s position=50,000/3.05m = 1.64%

Weighted Average Ratchet A =The shares outstanding before the financing = 2m B =The shares outstanding after the financing.= 2,050,000 C =The shares which have been issued for the price paid if the old (i.e., higher) conversion price had been used.=25,000 D=The shares actually issued at the new price. = 50,000

Weighted Average (Continued) P N = new conversion price =(A+C)/(B+D) =(2m+25,000)/(2,050,000+50,000)  $0.964/share (as opposed to $0.5/share)

Weighted Average: Before Founder: 1m/2m = 50% VC = 50% New Investor’s Position = 0

Weighted Average: After Founder’s equity position: 1m/[1m+(1m/$0.964)+50,000]  47.91% VC’s equity Position: 1,037,344/2,087,344  49.70% New investor’s position: 50,000/2,087,344  2.4%

Case B: Suppose Newco needs $25,000 cash. But the firm issues 250,000 shares of c/s at $0.1/share.

Full Ratchet: Before Founder: 50% VC: 50% New Investor: 0

Full Ratchet: After New shares = 250,000 From cp/s = 10 million shares(=1 mil/$0.1) Founder’s equity position = 1m/1m+10m+0.25m  8.89% (has been burned out) VC’s equity position = 10 mil/11.25 mil  88.89% (become lion’s share) New investor’s position= 250,000/11.25m  2.22%

Weighted Average A =The shares outstanding before the financing = 2 m B =The shares outstanding after the financing = 2.25 m C= The shares which have been issued for the price paid if the old (i.e., higher) conversion price had been used = 25,000 D =The shares actually issued at the new price = 250,000

Weighted Average P N = new conversion price = (A+C)/(B+D) = (2m+25,000)/(2.25m + 250,000) = 2,025,000/2,500,000 = $0.81/share

Weighted Average: Before Founder: 50% VC: 50% New investor’s postion: 0

Weighted Average: After New shares = 250,000 From cp/s = 1m/$0.81  1,234,568 Founder’s eq. position = 1m/(1m+1,234, ,000) = 40.25% VC’s eq. position = 1,234,568/2,484,568 = 49.69% New investor’s position =250,000/2,484,568 = 10.06%

Optional Bonus problem: Dilution and Anti-dilution Suppose a wireless Internet company, Halfdome Systems, desperately needs to finance $2 million in cash. Previously, founders own 5 million shares of common stock valued at $0.80 per share and other previous investors own 5 million shares of convertible preferred stock valued at $0.80 per share(Assume the price per share for common and convertible preferred is the same for simplicity). Due to their immediate need of new financing for their additional investment in R&D and for the recruitment of quality CEO, none of their previous investors wants to fund more because they are uncertain regarding the future of Halfdome. Instead, they recommend Battery Ventures who wants to invest into Halfdome Systems at $0.20 per share. While Battery Ventures wants to include a full ratchet anti-dilution in their term sheet, Chris Mais, founder of Halfdome wants to have a weighted-average ratchet. Since Chris is not quite familiar with this anti-dilution issue, he wants Santa Clara MBA consulting group to analyze the resulting ownership under two mutually exclusive anti-dilution methods, full ratchet vs. weighted average ratchet. Suppose you are a member of Santa Clara MBA consulting group.

Optional Bonus problem: Dilution and Anti-dilution (Cont’d) What should be the final percentage ownership for Chris Mais, previous investors, and Battery Ventures under the full ratchet and weighted average ratchet methods. Try two separate weighted average ratchet methods. Weighted average ratchet #1 is based on [(A + C)/(B + D)] x old conversion price where A = the number of shares outstanding before the new investment; B = the number of shares after the new investment; C = the number of shares which have been issued for the price if the old or higher conversion price had been used; and D = the number of shares actually issued at the new price. Weighted average ratchet #2 is using NCP (new conversion price) = [(OB * OCP) + New$] / OA where OB represents outstanding shares before offering, OCP refers old conversion price, New$ means an amount raised in offering, and OA stands for outstanding shares after offering. From the results of (i), what inferences can you make for entrepreneurs and venture capitalists? Discuss briefly.