Dilution: A Primer of Vocabulary
In the past I have had discussions with entrepreneurs and
investors about the concepts of "Dilution" and "Valuation". Because
there are often misconceptions about these terms, so here they are
clarified.
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. So, Dilution is really a
matter of what perspective you take.
Antidilution Protection.
So 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 (e.g. until the first $1 million
in equity is raised) 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 $.10 conversion
price) thereby resulting in the Founder owning 1/11th of the company and
the Investor owning 10/11ths.
Weighted average ratchet antidilution adjustment is better from the
Founder's viewpoint. Although the formulae used differ in some ways, the
basic approach is to adjust the conversion price to the average price
received by the company for stock issuances taking into account the
amount of money raised at different prices. A typical formula is as
follows:
NCP= [(OB*OCP) + New$] / OA
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.
Don't take definitions literally- different people mean different
things by the same words. So don't be afraid to ask. |
