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COVID-19: Down rounds and anti-dilution

28 April 2020

There is little doubt that the COVID-19 pandemic is going to impact the fundraising landscape and many early stage businesses may be required to consider emergency bridge funding and/or equity rounds at lower valuations which could amount to ‘down rounds.’

A key provision in a typical venture capital investment term sheet is anti-dilution protection, which provides that, if there is a down round, meaning an equity round at a lower price per share than the price paid by the investor benefiting from anti-dilution, new shares will be issued to such investor (typically at nominal value) to compensate it for the dilutive effect of the down round.

Founders and management teams should, however, be aware that there are several variations of anti-dilution protection, each of which, if enforced, will have a different impact on existing shareholders.

The most common of these is broad-based weighted average protection, which applies a mathematical formula to ‘weight’ the effect of the down round on the previous investor who has the benefit of such rights, taking into account the size and price of the down round relative to the fully diluted share capital of the company.

However, harsher variations include the narrow-based weighted average formula, which is similar to the broad-based approach, but ignores share options and other ‘unissued’ shares, thus having a more dilutive effect on existing shareholders, or the draconian ‘full ratchet’ protection, which re-bases the investor’s entire original investment to the lower price per share of the down round and maintains the investor’s full percentage ownership (irrespective of the size of the down round relative to the company’s overall share capital).

Time will tell if the downturn leads to VC investors demanding the more severe variations of anti-dilution protection, or if angel investors will begin to request similar mechanics (albeit note that this would likely negate the availability of S/EIS tax reliefs).

The temptation for founders at times like this may be to just sign what is put in front of them. However, agreeing to harsher variations of anti-dilution protection could prove hugely damaging over time, particularly given there is no real visibility as to how long the pandemic will last or impact on company valuations.

Early stage businesses should think carefully about the anti-dilution mechanics they agree to, if any, and also consider ways to mitigate their impact in practice. For example, the inclusion of ‘pay-to-play’ mechanics which require the investor holding anti-dilution rights to participate in any down round, or lose its right to be issued with anti-dilution shares.

Equally, founders should have a good understanding of any existing anti-dilution provisions in their company’s constitutional documents, whether these will be triggered by any financing under consideration and the likely impact if so.

Further, on the flip side, a savvy investor will think very carefully before enforcing existing anti-dilution rights, as this could have a de-motivating effect on a business’s management team.

In many cases, it may be more effective for anti-dilution provisions to be used as leverage to help negotiate new contractual protections, changes to management, or a shift in the direction of the business, rather than being enforced in full and punitively diluting key shareholders.

If you would like further information on this topic, you can contact Tony Littner or Tom Macleod.

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