The Basics of Dilution
Dilution connotes a decrease in something. As applied
to stock there are at least two dilution concepts - a
decrease in percentage ownership of a company (Percentage
Dilution) or a decrease in the economic value of an investment
(Economic Dilution).
Percentage Dilution. If Bill Gates owns 1,000
shares of Microsoft which represents 100% of the issued
and outstanding stock and Microsoft issues 1,000 shares
to Paul Allen, then Bill Gates' has experienced Percentage
Dilution in his ownership from 100% to 50%.
Economic Dilution. Note that a Percentage Dilution
in stock ownership has no direct relationship to the value
of that stock ownership position. The Board of Directors
of a company is supposed to determine that the company
has received fair value for the stock it issues. Of course,
the "value" of the stock can go up and down
over time. So if Bill Gates paid $1 per share for his
1,000 shares and Paul Allen comes along and buys 1,000
shares from Microsoft at a price of $2 per share, then
Bill Gates has experienced a Percentage Dilution but his
economic position has been increased from his initial
position. On the other hand, if Paul Allen buys his Microsoft
stock at a price of $.75 per share then Bill Gates has
experienced both Percentage Dilution and an Economic Dilution
from his initial $1.00 purchase price. Dilution from an
initial price is different than dilution from the current
price. For example, a sale at $.75 per share would not
represent an Economic Dilution from current value if the
fair market value of the stock was $.50 per share at the
time Paul Allen purchased and conversely, if Paul Allen
paid $2.00 per share there would be an Economic Dilution
from current value if the fair market value at the time
was $2.50 a share.
Antidilution Protection. What does it mean when
an Investor talks about receiving "Antidilution Protection"?
In some cases, usually rare, the Investor means that
his or her percentage ownership will always remain the
same as when the initial investment was made. What this
really means is that the other stockholders will "take
it on the chin" and experience more than their pro
rata portion of dilution. This type of Antidilution Protection
is most often used early on in a venture or if there are
some real questions about the current valuation.
In other cases, mainly with publicly traded securities,
the Investor means that he or she wants to be protected
from issuances of securities by the company at prices
below the then current fair market value. So the Investor
will be protected if he buys at $2.00 per share and the
company subsequently issues stock at $10.00 per share
at a time when the fair market value is $12.00 per share.
For the private company with professional venture capital
investors there is yet a third concept. Venture investors
often choose convertible preferred stock, convertible
debt or debt with warrants as their investment vehicle.
This gives them a position which is senior to or "ahead
of" the common stock if the company is sold or liquidated
but also allows them to participate in the "upside"
with the common stock if things take off. For example,
assume the investors purchase Series A Convertible Preferred
Stock at a price of $1.00 per share, which is initially
convertible at the option of the investor into one share
of common stock, a 1:1 conversion ratio. If the company
subsequently issues stock at a price less than the initial
$1.00 price paid by the investor then the conversion ratio
is adjusted so that one share of Preferred Stock will
be convertible to more than one share of common stock.
The conversion formula adjustment is typically referred
to as "antidilution protection" and there are
two types: full ratchet adjustment and weighted average
ratchet adjustment.
Full ratchet is the most onerous from the Founder's viewpoint.
If the company issues even one share of stock at a price
below the price paid by the investors then the conversion
price drops fully to that price. For example, assume the
Founder owns 1,000,000 shares of common stock and the
Investor purchases 1,000,000 shares of Convertible Preferred
Stock at a price of $1.00 per share, which is convertible
into common stock at that price ($1,000,000 initial purchase
price divided by $1.00 conversion price equals 1,000,000
shares of common stock) so that each owns 50% of the company.
Under a full ratchet if the company issues one share at
a price of $0.10 then the conversion price becomes $0.10
and the Investor can then convert his 1,000,000 shares
of Convertible Preferred Stock into 10,000,000 shares
of common stock ($1,000,000 initial purchase price divided
by $.10 conversion price) thereby resulting in the Founder
owning 1/11th of the company and the Investor owning 10/11ths.
Weighted average ratchet antidilution adjustment is better
from the Founder's viewpoint. Although the formulae used
differ in some ways, the basic approach is to adjust the
conversion price to the average price received by the
company for stock issuances taking into account the amount
of money raised at different prices. A typical formula
is as follows:
where:
NCP = New Conversion Price
OB = Outstanding Shares Before Offering
OCP = Old Conversion Price
New$ = Amount Raised in Offering
OA = Outstanding Shares After Offering
This formula is applied only if the price in the offering
is less than the old conversion price.
By Joe Hadzima
