Advanced

A comparative study of anti-dilution protection in the US and in Sweden

Nyborg, Linda (2004)
Department of Law
Abstract
Convertible preferred shares are, the most frequently used investment instrument in venture capital or private equity investment. The various rights associated with these shares make them more valuable than ordinary shares. A vital feature, at least for the US venture capitalist, is the conversion right that is the right to convert a preferred share into an ordinary share. For the right of conversion to be meaningful anti-dilution clauses are generally attached to convertible preferred shares to guarantee that adjustments of the conversion price will be made to protect the investment against dilution in the event of a subsequent investment round at a lower valuation. Anti-dilution protection provisions, before considered as standard... (More)
Convertible preferred shares are, the most frequently used investment instrument in venture capital or private equity investment. The various rights associated with these shares make them more valuable than ordinary shares. A vital feature, at least for the US venture capitalist, is the conversion right that is the right to convert a preferred share into an ordinary share. For the right of conversion to be meaningful anti-dilution clauses are generally attached to convertible preferred shares to guarantee that adjustments of the conversion price will be made to protect the investment against dilution in the event of a subsequent investment round at a lower valuation. Anti-dilution protection provisions, before considered as standard provisions not worthy any attention or negotiation, have today become highly controversial clauses. The primarily purpose of anti-dilution protection is to protect against changes in the exchange ratio and in doing so insure that the percentage of the total number of underlying shares deliverable upon conversion will remain stable despite alteration in the company's share capital structure. The anti-dilution equation works like this: initially the new subscription/conversion price is equal to the original subscription price and the conversion ratio is therefore one to one&semic that is one common share for one preferred share. After a down round the conversion price drops down, yielding a higher conversion ratio than one to one. The outcome is that the investor obtains additional shares in the company without further costs. There are principally two different anti-dilution formulas, ''the weighted average'' and ''the full ratchet''. ''The weighted average formula'' reduces the original subscription price to an amount between itself and the price per share in the later round of financing and is the more modest formula, as it takes into account the amount of shares sold in the down round. ''The full ratchet'', at the other hand, is much more powerful and provides a complete protection of the investment in the event of a dilutive issue. This is accomplished by dropping the original subscription price to the new subscription price in the subsequent investment round and issue enough additional shares for free to the venture capitalist to make his/her average cost per share equal to the price per share in the down round. Anti-dilution protections facilitates further investment rounds in the relevant company which, is not only advantageous to the company in that it provides a mechanism within the original investment structure through which future funding can be accommodated, but also for the venture capitalist who may have overvalued the company and due to the anti-dilution protection can avoid or reduce the consequences of this miscalculation of the value of his investment. The implementation of especially a ''full ratchet'' clause may, however, wipe out the management's motivation to operate in the best interest of the company, as it drastically reduces the founders' ownership. The investor-founder relationship may further be harmed by introducing elements of mistrust and diverging interests in the relationship which may diminish the future possibility of a successful exit. The Swedish venture capital market is in many ways similar to the US market. The Swedish Companies Act does not, however, permit flexible conversion ratios to be included in the articles of association. Hence, the conversion ratio method cannot be used in Sweden. The logic behind anti-dilution protection in Sweden is instead of adjusting and protecting the conversion ratio, to protect the value of the investment by issuing additional ''anti-dilution shares'' to an amount equivalent to the nominal value of theses shares to the investor. This protection is guaranteed by e.g. contractual undertakings by the existing shareholders in a shareholders' agreement. The cons with such a solution are the uncertainty concerning the enforceability of this agreement in different situations. It is therefore extremely important for the investor to grant full adherence to the shareholders' agreement. A more solid solution is to issue ''anti-dilution warrants'' to the investor, which entitle him/her to subscribe for new shares at the nominal value in connection with the relevant issue. Thus, the investor can exercise the warrants in the event of a down round and does not have to rely on the other shareholders. Shares cannot be issued for free in Sweden&semic consideration amounting to at least the nominal value must be paid to the company. Customary, it is the investor who pays this amount, which has to be taken into account when designing the anti-dilution protection. The payment of the nominal value is not a big problem in practice, since most shares in venture capital sustained companies have a low nominal value and the company can reduce this value if necessary by a share split or similar actions. Except for the nominal value the parties must consider the provisions regarding the size of the company's share capital and the compulsory obligation to liquidate the company if its equity is less than half of the registered share capital and, the financial situation has not improved within the specified time in such a way that its equity amounts to the registered share capital. The design of the anti-dilution protection is in the end a question of negotiations. A number of issues should be discussed in advanced. The first and most important issue is, of course, whether anti-dilution provisions should be included at all. The next step is to choose formula and, in the Swedish context, to decide how to design and guarantee this protection. Other important issues are the class of shares of ''the anti-dilution shares'', which events that should trigger these protective provisions, i.e. should certain issues be exempted, pay to play provisions and which price that should decide whether the subsequent round is a down round or not. These are merely some examples of specific problems that the parties should try to agree on in advance. Every investment is, however, unique and the parties have to consider the specific circumstances in each case when designing the anti-dilution protection. Careful drafting and an understanding for the significance and the consequences of anti-dilution protection are vital ingredients in these negotiations and may pave the way for a successful co-operation between the investor and the entrepreneurs. (Less)
Please use this url to cite or link to this publication:
author
Nyborg, Linda
supervisor
organization
year
type
H3 - Professional qualifications (4 Years - )
subject
keywords
Associationsrätt
language
English
id
1560793
date added to LUP
2010-03-08 15:55:27
date last changed
2010-03-08 15:55:27
@misc{1560793,
  abstract     = {Convertible preferred shares are, the most frequently used investment instrument in venture capital or private equity investment. The various rights associated with these shares make them more valuable than ordinary shares. A vital feature, at least for the US venture capitalist, is the conversion right that is the right to convert a preferred share into an ordinary share. For the right of conversion to be meaningful anti-dilution clauses are generally attached to convertible preferred shares to guarantee that adjustments of the conversion price will be made to protect the investment against dilution in the event of a subsequent investment round at a lower valuation. Anti-dilution protection provisions, before considered as standard provisions not worthy any attention or negotiation, have today become highly controversial clauses. The primarily purpose of anti-dilution protection is to protect against changes in the exchange ratio and in doing so insure that the percentage of the total number of underlying shares deliverable upon conversion will remain stable despite alteration in the company's share capital structure. The anti-dilution equation works like this: initially the new subscription/conversion price is equal to the original subscription price and the conversion ratio is therefore one to one&semic that is one common share for one preferred share. After a down round the conversion price drops down, yielding a higher conversion ratio than one to one. The outcome is that the investor obtains additional shares in the company without further costs. There are principally two different anti-dilution formulas, ''the weighted average'' and ''the full ratchet''. ''The weighted average formula'' reduces the original subscription price to an amount between itself and the price per share in the later round of financing and is the more modest formula, as it takes into account the amount of shares sold in the down round. ''The full ratchet'', at the other hand, is much more powerful and provides a complete protection of the investment in the event of a dilutive issue. This is accomplished by dropping the original subscription price to the new subscription price in the subsequent investment round and issue enough additional shares for free to the venture capitalist to make his/her average cost per share equal to the price per share in the down round. Anti-dilution protections facilitates further investment rounds in the relevant company which, is not only advantageous to the company in that it provides a mechanism within the original investment structure through which future funding can be accommodated, but also for the venture capitalist who may have overvalued the company and due to the anti-dilution protection can avoid or reduce the consequences of this miscalculation of the value of his investment. The implementation of especially a ''full ratchet'' clause may, however, wipe out the management's motivation to operate in the best interest of the company, as it drastically reduces the founders' ownership. The investor-founder relationship may further be harmed by introducing elements of mistrust and diverging interests in the relationship which may diminish the future possibility of a successful exit. The Swedish venture capital market is in many ways similar to the US market. The Swedish Companies Act does not, however, permit flexible conversion ratios to be included in the articles of association. Hence, the conversion ratio method cannot be used in Sweden. The logic behind anti-dilution protection in Sweden is instead of adjusting and protecting the conversion ratio, to protect the value of the investment by issuing additional ''anti-dilution shares'' to an amount equivalent to the nominal value of theses shares to the investor. This protection is guaranteed by e.g. contractual undertakings by the existing shareholders in a shareholders' agreement. The cons with such a solution are the uncertainty concerning the enforceability of this agreement in different situations. It is therefore extremely important for the investor to grant full adherence to the shareholders' agreement. A more solid solution is to issue ''anti-dilution warrants'' to the investor, which entitle him/her to subscribe for new shares at the nominal value in connection with the relevant issue. Thus, the investor can exercise the warrants in the event of a down round and does not have to rely on the other shareholders. Shares cannot be issued for free in Sweden&semic consideration amounting to at least the nominal value must be paid to the company. Customary, it is the investor who pays this amount, which has to be taken into account when designing the anti-dilution protection. The payment of the nominal value is not a big problem in practice, since most shares in venture capital sustained companies have a low nominal value and the company can reduce this value if necessary by a share split or similar actions. Except for the nominal value the parties must consider the provisions regarding the size of the company's share capital and the compulsory obligation to liquidate the company if its equity is less than half of the registered share capital and, the financial situation has not improved within the specified time in such a way that its equity amounts to the registered share capital. The design of the anti-dilution protection is in the end a question of negotiations. A number of issues should be discussed in advanced. The first and most important issue is, of course, whether anti-dilution provisions should be included at all. The next step is to choose formula and, in the Swedish context, to decide how to design and guarantee this protection. Other important issues are the class of shares of ''the anti-dilution shares'', which events that should trigger these protective provisions, i.e. should certain issues be exempted, pay to play provisions and which price that should decide whether the subsequent round is a down round or not. These are merely some examples of specific problems that the parties should try to agree on in advance. Every investment is, however, unique and the parties have to consider the specific circumstances in each case when designing the anti-dilution protection. Careful drafting and an understanding for the significance and the consequences of anti-dilution protection are vital ingredients in these negotiations and may pave the way for a successful co-operation between the investor and the entrepreneurs.},
  author       = {Nyborg, Linda},
  keyword      = {Associationsrätt},
  language     = {eng},
  note         = {Student Paper},
  title        = {A comparative study of anti-dilution protection in the US and in Sweden},
  year         = {2004},
}