Author Name:   yamini.khurana

Anti Dilution Protection to the existing investors during the second round of financing at a lower rate than the first round of financing...

Anti Dilution Protection

It is not uncommon for private equity or venture capital backed portfolio companies to raise multiple rounds of financing to fund the growth of their businesses. These subsequent financings usually reflect portfolio company valuations that have risen since the last round. However, this is not always the case and this is where Anti Dilution comes into existence. The term Anti Dilution essentially denotes that when a company receives a second round of funding at a price per share that is lesser than the price the shares fetched in the first round of funding, the first round investors by exercise of the anti-dilution clause are protected from the resultant stock dilution. Such an environment may result in “down rounds” whereby investors subscribe for shares from a company at a lower valuation than that placed upon the company by earlier investors. Down rounds may result in substantial dilution to the founders, employees and to existing investors. In an extreme situation, the existing shareholders may be washed out or crammed down such that their shares or options are not worth much.

This right basically says that in future, the company can’t issue shares to new investors (“Series B”) investor at price which is lower than the price paid by previous set of investors (“Series A”) investor.

To understand this right, let’s consider the following example:
1. Let us assume that the Series A investor has invested Rs. 10 Cr. in a company for 20% stake by subscribing to 10,00,000 shares out of the total 50,00,000 shares. It implies that the value of each share is Rs. 100 (Rs. 10,00,00,000 Cr. divided by 10,00,000 shares).

2. Let us also assume that the company has given Anti-dilution right to the Series A investor. It would ensure that if the company issues any shares in future to Series B investor the pre-money price of each share can’t be less than Rs. 100 or the company will have to compensate the Series A investor from any dilution by issuing them additional shares.

Adjustment For Shares Sold Over Conversion Price
The anti dilution protection is not extended to the investors in a situation where the price of additional shares issued is higher than the price at which those shares were issued previously. The definition of additional shares of common stock is followed by a provision making it clear that there will be no adjustment for shares sold at a price per share in excess of the conversion price. From financial point of view, issuances at a price per share greater than the conversion price would be accretive rather than dilutive.

Exceptions
There are certain exclusions to the applicability of the anti-dilution clause. The following may be included in a shareholders agreement as an exception to the exercise of Anti Dilution Right by the companies:
· Employee Stock Options (ESOPs)
· Shares issued for consideration other than cash and this usually happens in scenarios of merger, amalgamation, acquisition, consolidation etc
· Shares with respect to which the holders of a majority of the outstanding Series A investors waive their anti-dilution rights.

This exception has been found to be very helpful in those deals where a majority of the Series A investors agree to further fund a company in a follow-on financing, but the price will be lower than the original Series A. In this example, it might happen that several minority investors signal that they are not planning to invest in the new round, as they would prefer to sit back and increase their ownership stake via the anti-dilution provision. Having the major investors step up and vote to carve the financing out of the anti-dilution terms was a huge bonus for the company common holders and employees who would have suffered the dilution of additional anti-dilution from investors who were not continuing to participate in financing the company. This approach encourages the minority investors to participate in the round in order to protect themselves from dilution.

· Anchor investors
· Relatives of promoters.

Indian Scenario
In India, the use of anti-dilution mechanisms is still new and has yet to be thoroughly tested. In India, interests of the investors, if an additional round of financing is carried out by the company, are protected through the presence of various clauses in the Shareholders Agreement executed between the company, the investors and the promoters of the Company. In the said Agreement the interest of investors are well protected by provision of various anti-dilution provisions.

There are two types of anti-dilution protection, pre-emptive rights to subscribe to purchase shares in new offerings and anti-dilution protection in down rounds.

· In India, pre-emptive rights can only be exercised by shareholders of private companies to acquire existing and new shares of that company. Pre-emptive rights afford the venture capital investor the right to subscribe to it’s pro rata share of the next round to maintain its pro rata ownership interest in the company. The venture capital investor has the option to subscribe to additional equity of the company before the subscription is offered to any third party. The typical provision states that the subscription can be offered to third parties only after the venture capital investor declines it. Further, restrictions are also placed on the transfer of equity from existing shareholders to non-shareholders.

However, these provisions are available only if the company does not make an Initial Public Offer or converts itself into a public limited company in India. Pre-emptive rights, or any rights providing special privileges to a certain set of shareholders with regard to the issuance of shares, are not permitted under the Indian Companies Act, 1956.

· The other type of anti-dilution is to adjust the shareholder’s conversion ratio if the price per share of the stock issued in any subsequent round of financing is less than the price per share which the shareholder paid for his stock. There are two basic types of anti-dilution protection: Full/Part Ratchet method and the Weighted Average method.

Full-Ratchet Method
The full-ratchet method is the harshest and most punitive investor protection against a “down round”. Full-ratchet anti-dilution protection gives the original investor rights to that number of shares of common stock as if he paid the current round’s lower price.

The National Venture Capital Association defines full-ratchet as – the conversion price will be reduced to the price at which the new shares are issued.

The full ratchet anti-dilution adjustments clause is incorporated in order to secure any future issue of shares at a lower price, which may lead to a dilution of the existing equity and a decline in the existing value of the shares. In the event the company allots additional shares in future at a price lower than the price paid by the investor, this process calls for an adjustment of the differential amount to be made, which is ascertained by lowering the conversion price of the equity so that the acquirer or investor is entitled to more shares upon conversion. For example, if an investor has paid a price of Rs.100 per share at the time of making the investment and subsequently the shares are allotted at Rs. 70 to the other shareholders, then the adjustment of Rs. 30 has to be made in favor of the acquirer/investor by compensating him either monetarily or by giving him bonus shares.

One can get creative and do “partial ratchets” (such as “half ratchets” or “two-thirds ratchets”) which are a less harsh, but rarely seen.

Weighted Average Method
Weighted average method prescribes a formula, which accounts for both size and price of later financing, so it is very neutral to both preferred and common stockholders. Weighted Average anti-dilution protection gives consideration to the relationship between the total shares outstanding as compared to the shares held by the original investor. The legal language that is used in a term sheet to say this is:

“In the event that the Company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be adjusted in accordance with the following formula: CP2 = CP1 * (A B) / (A C)”

Thus, in the full-ratchet mode if the company sold one share at a price lower than the Series A, all of the Series A shares will be re-priced at the new issue price. In the weighted average mode, the number of shares issued at the reduced price is considered in the re-pricing of the Series A.

I believe the most common form of anti-dilution provision and the one that causes least damage to founders is the weighted average anti dilution clause.

Benefits
Investors
Investors usually invest in a company with the hope that successive valuations will be higher and the return that the company can promise to its investors will successively be an increase. However, market conditions may result in significant valuation swings in different market cycles and the anti-dilution is a material provision that investors seek for protection and is usually considered an automatic right. Promoters should not be averse to this provision and may do well to remember that if not for this clause they may have never got funded in the first place.

Company
The anti-dilution clause encourages the company to seek higher valuations at all times and incentivises the company to better perform towards this end. Though rare, it is not unheard of for anti-dilution clauses to be linked to milestone based performances. In these cases, the clause will kick in automatically.

Control Impacts
In addition to economic impacts, anti-dilution provisions can have control impacts. First, the existence of an anti-dilution provision incents the company to issue new rounds of stock at higher valuations because of the ramifications of anti-dilution protection to the common stock holders. Second, a recent phenomenon is to tie anti-dilution calculations to milestones the investors have set for the company resulting in a conversion price adjustment in the case that the company does not meet certain revenue, product development or other business milestones. In this situation, the anti-dilution adjustments occur automatically if the company does not meet in its objectives, unless this is waived by the investor after the fact. This creates a powerful incentive for the company to accomplish its investor-determined goals.

Sebi’s View And Problems Linked With Anti Dilution Protection
SEBI’s Views
Anti-dilution mechanisms have been tested internationally however and carry their own legal risks, some of which are applicable to the Indian scenario.

The Securities and Exchange Board of India (SEBI) has strongly come out against an idea to water down norms governing listing of small and medium size enterprises on the stock exchanges. The capital market regulator is of the view that the dilution of the norms will increase risks. Mr. Pratip Kar has said that instead of dilution, which triggers arbitrage and exploitation of regulatory inconsistencies, efforts should be to create market designs that will ensure liquidity to help for small and medium enterprises raise funds easily.

Problems
Indian law poses certain practical difficulties in giving effect to this kind of a ratchet mechanism. Indian company law requires that no shares can be issued by a company at a discount to par value. Therefore, it is not possible to issue shares at no cost to any shareholder as envisaged in the ratchet mechanism. One has to find indirect and often complicated means of funding the ratchet.

· The key consideration is how India’s floor price rules can affect the desired economics of the down round. These rules apply in a variety of situations, including equity subscriptions from listed and unlisted companies and purchases from Indian residents.

For listed companies, the floor price is found in the Securities and Exchange Board of India’s Takeover Code and is commonly known as the “SEBI Price”. The SEBI price is defined as the higher of (i) the average of the weekly high and low closing prices during the twenty six months preceding the date of the public announcement of the relevant share issuance and (ii) the average of the daily high and low closing prices during the two weeks preceding the date of the public announcement.

The SEBI Price is backward-looking, computed on the basis of historical information. In a down round, the proposed value of a new share issuance by the portfolio company will typically be based on forward looking expectations as to future cash flow and profitability, but the backward-looking nature of the floor price calculations can operate to prevent new equity from being issued at a price below the applicable floor price.

A related point is that an existing investor’s anti-dilution protection cannot “ratchet down” the investor to a per share price that is lower than the floor price that is applicable to its existing investment, or involve the issuance of shares at a zero value, nominal or other reduced value that is below the applicable floor price.

· Board members who are representatives of investors may face a conflict of interest in considering the terms of a down round. This is because such directors may negotiate the terms of the down round on behalf of their investors and also have to approve the transaction in their role as a director of the company.

· Down rounds also typically result in changes in the voting percentages of various existing shareholders, which can have important legal consequences under India’s corporate law. For example, any investor whose percentage equity holding in a listed Indian company exceeds 15% is required to make an “open offer” to all shareholders to acquire at least 20% of the shares it does not already own. This “open offer” must be made at the higher of the SEBI Price and the highest price paid by the investor during the 26-week period preceding the date of the public announcement of the acquisition of shares that took it above the 15% threshold.

Likewise, certain minority rights arise as a function of voting percentages. For instance, the passage of a special resolution by shareholders of an Indian company requires a 75% supermajority vote (and can therefore be blocked by a shareholder holding more than 25% of the company’s equity). Similarly, holders of 10% or more of an Indian company’s equity can make statutory “oppression of the minority” claims.

The rights and obligations that arise from shifting voting percentages can significantly impact a company’s ability to successfully execute a down round. New or existing investors may, for example, decline to participate because of reluctance to cross the 15% threshold and trigger an “open offer” obligation. Likewise, existing shareholders may be reluctant to give necessary consents or waivers if the down round will result in a new or existing shareholder obtaining a voting percentage that gives it the ability to block special resolutions or make statutory “oppression of the minority” claims or if the dilutive impact of the down round would result in existing shareholders losing the benefit of these protections.

· The full ratchet and weighted average mechanisms can greatly complicate the ability of a portfolio company to execute a down round, because they serve to shift some or all of the negative impact of a down round onto the shareholders who do not have such protections in place (typically the founders and employees, and in some cases later-stage investors as well).

As a practical matter, the successful completion of a down round often depends on the waiver by protected investors of some or all of their anti-dilution adjustments. Since there is no guarantee that these waivers can be obtained, however, portfolio companies that anticipate this risk can seek to mitigate it by insisting on weighted average rather than full ratchet anti-dilution adjustments, and perhaps insisting on a “pay to play” provision that requires the protected investor to participate in the new round in order to receive the benefit of its anti-dilution adjustments.

· Anti dilution provision can cause a substantial dilution of the equity of existing shareholders, in addition to having a considerable impact on a company’s financial resources. The adjustment in the price of shares and the cost of issuing additional equity has to be borne by the company. This is particularly hard for smaller companies that are owned by family members who are the main investors. The adjustment in price is usually done through stock splits, declaring dividends and issuing bonus shares.

· A key business problem encountered in down rounds is avoiding excessive dilution of the equity stakes held by the management team and other key employees, which can remove incentives that might be crucial to the portfolio company’s success. Heavy dilution of management and employee stakes may be unavoidable at the outset of the down round due to the simple mathematics of the round, given the amount of new equity required and the depressed valuation at which the round must take place. This problem is exacerbated by the fact that management and employees typically lack access to the capital needed for them to participate in the down round, even if they are nominally offered the ability to participate, and can be further compounded by the impact of the anti-dilution adjustments discussed above.

Conclusion
India has become a favourite destination for foreign funds, given its exemplary growth rate. Methods of limiting the conflict and legal risk could be to utilise a committee of those directors who are not appointed by the investors to approve the transaction, obtaining approval of all fully informed shareholders and/or obtaining an independent valuation to set a fair price for the financing. Although investments always have risks attached, one can minimize these by making appropriate provisions at the time of executing the investment agreement. Companies should focus on (a) minimizing the impact of anti-dilution protection and (b) build value in their company after the financing so that anti dilution protection never comes into play.
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# The Author is a 5th year law student of Symbiosis Law School, Pune, Maharashtra.
# The Co-author is a 5th year law student of Symbiosis Law School, Pune, Maharashtra.
# Anchor investor means a qualified institutional buyer making an application for a value of ten crore rupees or more in a public issue made through the book building process in accordance with SEBI (ICDR) Regulations. With a view to create a significant impact on pricing of initial public offers, SEBI introduced the concept of “anchor investor” in public issues vide its circular dated July 9, 2009.
# The National Venture Capital Association (NVCA) is the leading trade association representing the venture capital industry in the U.S. (http://www.nvca.org/)
# CP2 - new conversion price; CP1 - old conversion price; A - common stock outstanding; B – “what the buyer should have bought if it had not been a ‘down round’ issuance” (common stock purchasable with consideration received by company); C - “what the buyer actually bought” (common stock actually purchased in subsequent issuance).
# Ex-Executive Director of SEBI
# Section 79, Companies Act, 1956
# Section 20, Securities And Exchange Board Of India (Substantial Acquisition Of Shares And Takeovers)Regulations, 1997
# Section 21, Securities And Exchange Board Of India (Substantial Acquisition Of Shares And Takeovers)Regulations, 1997

The  author can be reached at: yamini.khurana@legalserviceindia.com

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