Price-based anti-dilution is triggered when a company raises additional money at a lower post-money valuation than the previous post-money valuation (i.e., a down round). For example, if a company raises a Series Seed round at a post-money valuation of $50 million and then raises a Series A round at a post-money valuation of $40 million, the Series A round would be considered a “down round” because the post-money valuation is $10 million less after the Series A round.

Since the post-money valuation is less after the Series A round, we know that the price per share of the Series A preferred stock will be less than that of the Series Seed preferred stock (read more about the calculation of the price per share in “Is the Math Correct?”). To protect the existing investors from their preferred stock being priced below that of the newly issued preferred stock, the charter often includes a section that adjusts the existing share price and gives the existing investors either (i) additional shares of common stock (upon conversion of the preferred stock) based on a formula that takes into account the average of all of the outstanding share prices paid by investors (i.e., the broad based weighted average formula) or (ii) adjusts the existing investors’ share price to be equal to that of the lowest price per share (i.e., full ratchet).

The broad-based weighted average formula adjusts the conversion price for the investors by using a weighted average formula based on the money previously raised, the new money being raised, the old share price, and the new share price. A broad-based weighted average formula takes into account the fully-diluted capital of the company to lessen the effects of the dilution to the common stockholders. A typical broad-based weighted average formula is as follows:

CP2 = CP1 * (A+B) ÷ (A+C):

• CP2 = new conversion price at which the existing investors will be able to convert their preferred stock into common stock.
• CP1 = prior conversion price of the existing preferred stock.
• A = fully-diluted capitalization prior to the new issuance, including:
  • all shares of outstanding common stock;
  • all shares of outstanding preferred stock and convertible notes on an as-converted basis; and
  • all outstanding options and warrants on an as-exercised basis.
• B = Dollar amount raised in the down round divided by the prior conversion price.
• C = number of shares of stock issued in the down round.

As an example, suppose 1,000,000 shares of Series Seed preferred stock are outstanding at $5 per share, and convert at a 1:1 ratio. The company also has 1,000,000 shares of common stock outstanding and 1,000,000 options outstanding for a total fully-diluted capitalization of 3,000,000 shares. Assume the Company’s charter has anti-dilution protection and uses the broad-based weighted average formula.

Now, imagine the company does a subsequent financing round and issues 1,000,000 shares of Series A preferred stock at $3 per share. Because the Company did a subsequent financing round in which the price per share was lower than in the previous round, the anti-dilution protection would kick in. Using the broad-based weighted average formula, the new conversion price for the Series Seed Preferred stock would equal to $3.75:

$5 x (3,000,000 + [$3,000,000/$5]) / (3,000,000 + 1,000,000)

The existing stockholders would be given the option to convert their shares at $3.75 per share in a liquidity event instead of $5, resulting in the investors receiving more shares of common stock, if and when their shares convert.

This formula also uses a weighted average formula, but the shares used to calculate the conversion price are narrower such that the formula often includes only shares of common stock that are outstanding and not shares that are convertible into common stock (i.e., options, warrants, and sometimes preferred stock). This is more investor-friendly than broad-based weighted average, but still not as investor-friendly as a Full ratchet formulation.

This formula adjusts the new conversion price to the lowest conversion price implied by any financing round. Using the example above, the Series Seed shares will be adjusted to a conversion price of $3 per share. This formula takes the lowest price per share and applies it to the outstanding shares of preferred stock. This is an uncommon form of anti-dilution protection as it is extremely investor friendly and causes the most dilution to the founders and other early employees.

In addition to outlining the mechanics of price-based anti-dilution, the company’s charter will list additional shares of common stock that can be issued without triggering the price-based anti-dilution protection listed above. These carve outs typically include the following, all of which may be subject to board approval:

1. Shares issued as dividends, stock splits, or other distributions;
2. Shares issued to employees, directors, or consultants pursuant to an equity incentive plan;
3. Shares issued upon the exercise of options or convertible securities;
4. Shares issued to banks pursuant to debt financings; or distributions on preferred stock;
5. Shares issued to third parties in connection with the provision of goods and services;
6. Shares issued as acquisition consideration; and
7. Shares issued in connection with strategic partnerships.