Beware Of Getting Diluted Out Of Your Profits

So, you think you have antidilution protection? Think again. It may be time to double check your documents.

Suppose you’re in a deal where you have a minority ownership stake in a privately held company. Maybe you’re a mezzanine investor with warrants or a co-investor with preferred stock or maybe you are part of the management team with skin in the game. Not surprisingly, the company you are invested in is having some difficulty and it needs more capital. Since you don’t have the appetite to invest any more in the company, you decide to go along with what the equity sponsor is proposing in terms of additional equity. Your thought process is that you have antidilution protection (you remember seeing the heading in one of the documents) and as a result, your economic investment won’t be severely impacted. You can take the hit since you are not investing alongside with the equity sponsor in the equity financing. After all, you must have weighted average antidilution protection because that’s “market” and that’s what you always get.

In fact, you call your attorney and he explains that you do have weighted average antidilution protection. You breathe a sigh of relief, but then your attorney explains that the trigger for antidilution is based on fair market value. That is, your weighted average antidilution protection only kicks in if there is an issuance of stock at a price less than the current market price of the stock. Isn’t the current market price the price paid in the new issuance? Does that mean there is no antidilution protection?

Unfortunately, since your antidilution protection is keyed off of issuances of stock below the then-current market price, any new issuances of stock will likely not trigger your antidilution protection without an independent appraisal to determine the value of the stock.

The Antildilution Triggers

Regardless of the type of price-based antidilution protection agreed upon in any given transaction, be it full ratchet or weighted average (broad based or narrow based), antidilution protection is typically keyed off of a particular event. That is, issuances of stock at a below-market price or agreed upon price. There are typically two types of events that trigger the price based antidilution formula: (1) issuances of stock below the then-current market price and (2) issuances of stock below the exercise price or conversion price of the convertible security (typically set at a price equal to the price per share at the time of the initial investment).

Current Market Price Trigger

The antidilution trigger event based on the current market price model is designed to protect the holder of convertible securities against issuances of stock (or deemed issuances of stock) at a price less than the current market price. The rationale underlying this approach is that dilution occurs whenever a company issues equity securities at less than the fair market value of such equity securities. When the exercise price or conversion price is less than the current market price of the equity security, the difference represents the true value of the underlying equity security. If a company issues equity securities at a price greater than or equal to the exercise price or conversion price but less than the current market price, the equity security loses value. There is no protection against this loss under the traditional weighted average formula where the trigger is keyed off of the exercise price or conversion price. This is where the current market price model is effective protection against issuances below the current market price to preserve the underlying value of the convertible security.

Under the current market price model, where the antidilution formula is keyed off of issuances of new equity securities below the current market price, the exercise price or the conversion price and the convertible shares are adjusted pursuant to a weighted-average formula typically written as follows:

NCP = CP * [(IOS x CMP) + (NS x IP)]/[(IOS + NS) x CMP)]

NCP= New Conversion Price, CP= Conversion Price in effect prior to new issuance, IOS= Issued and Outstanding shares prior to the issuance, IP= Price of new shares issued, NS= New shares issued, CMP=Current Market Price

One of the biggest drawbacks in using the current market price model in the private company context is the valuation of the securities. Since there is no public market for a privately held company, it is difficult to determine the current market price of the equity security being issued without an independent appraisal. In order to receive the benefits of the current market price model when there is no public market for the equity security, one would need to engage an independent appraisal each time there is a new issuance of equity securities. This can be very cumbersome and expensive. Without an independent appraisal, however, the company issuing the equity securities can argue that the current market price for the issued securities is the price being paid in the new issuance. This price could be lower than the original price paid in the initial transaction. Even if one incurs the time and expense of engaging an independent appraisal, the current market price determined by the independent appraisal could very well be the price paid in the new issuance. In which case, there would be no antidilution protection. As a result, the current market price model does not fully protect one’s equity investment where there are decreases in the fair market value of the equity security.

Exercise Price or Conversion Price

The antidilution trigger event based on the exercise price or conversion price is designed to protect the holder of convertible securities against issuances of stock (or deemed issuances of stock) at a price less than the exercise price or conversion price. The use of the exercise price or conversion price as the trigger for price based antidilution protection is fairly standard in the private company context. In contrast to the current market price model where the use of a fair market value standard is subjectively determined, the exercise price or conversion price is a number that is determined at the time of the initial investment and any adjustments can be calculated objectively. The exercise price or conversion price also has some relation to the value of the convertible security.

Under the exercise price or conversion price trigger, where the antidilution formula is keyed off of issuances of new equity securities below the exercise price or conversion price, the formula for weighted-average antidilution is typically written as follows:

NCP = [(IOS x OCP) + (NS x IP)]/(IOS + NS)

NCP= New Conversion Price; IOS= Issued and Outstanding shares prior to the issuance; IP= Price of new shares issued; NS= New shares issued; OCP= Original Conversion Price (or Purchase Price Per Share)

Number of Shares Following Adjustment=(OCP * Number of Shares Owned)/NCP

As noted above under the heading “Current Market Price Trigger,” however, an antidilution trigger event based solely on exercise price or conversion price is not without its own shortcomings. Under the exercise price or conversion price model, there is no protection under the traditional weighted average formula for issuances of equity securities at a price greater than or equal to the exercise price or conversion price but less than the current market price. The true value of the underlying security is diminished when there are issuances below the then current market price but greater than the exercise price or conversion price. Any protection from this trigger event assumes that the existing shares have a value equal to the exercise price or conversion price. Under this approach, an investor will not obtain the benefit of any increases in the value of the equity securities since the investor has essentially locked in the price for dilutive issuances set at the initial closing without regard to any price increases to the equity securities. Antidilution protection is essentially lost over time and the true value of the underlying equity security is diminished when the value of the equity securities have increased and new issuances of stock are issued at a price that is below the then current market price of the stock but greater than the exercise price or conversion price. As a result, an antidilution trigger based solely on exercise price or conversion price does not fully protect one’s equity investment when there are substantial increases in the price of the equity securities.

Scenarios

Below are two examples that illustrate the effects of a dilutive issuance based on a current market price trigger and an exercise price or conversion price trigger.

• At the initial closing, co-investor purchases 100 shares of preferred stock for $10.00 per share, convertible into 100 shares of common stock, representing 10 percent of the common stock on a fully diluted and as converted basis (or 1,000 shares of common stock outstanding);

• The company is in need of additional equity capital as a result of a decline in the business and issues 100 shares of preferred stock for $5.00 per share to the equity sponsor;

• Equity sponsor asserts that the current market price is $5.00 per share (no independent appraisal conducted); and

• Conversion price is $10.00 per share.

Current Market Price

Based on the facts above, the new conversion price calculation of the weighted average adjustment under a current market price trigger is $10.00. Since the current market price ($5.00) is equal to the price of the newly issued shares ($5.00), the co-investor is not entitled to any price based antidilution protection. In fact, the antidilution formula would not be triggered because the issuance of stock was not less than the current market price of the stock. In any event, running the calculation through the formula yields the same results. That is, the co-investor can only convert the preferred stock into 100 shares of common stock of the company since there was effectively no adjustment. The co-investor’s ownership percentage, however, decreases from 10 percent to 9.09 percent (100/(1,000+100)), a loss of 0.91 percent from the original 10 percent held by the co-investor and a decrease of $45.55 to $954.45 in the value of the original investment of $1,000 ($10,000 original post-money valuation plus $500 raised in dilutive financing multiplied by the new ownership percentage of 9.09 percent).

Exercise Price Or Conversion Price

Based on the facts above, the new conversion price calculation of the weighted average adjustment under an exercise price or conversion price trigger is $9.545. The number of shares following adjustment is 104.76. Since the price of the newly issued equity securities is less than $10.00, the co-investor is entitled to price based antidilution protection. In fact, the co-investor would be entitled to purchase 104.76 shares, or 9.52 percent of the issuer on a fully diluted basis following the adjustment (as compared to 100 shares, or 9.09 percent, of the fully diluted common stock of the issuer, under the current market price trigger). As a result, the co-investor’s ownership percentage decreases from 10 percent to 9.52 percent (104.76/(1,000+100)), a loss of 0.48 percent from the original 10 percent held by the co-investor, rather than a loss of .91 percent under the current market trigger, but the weighted average value continues to equal $1,000 ($10,000 original post-money valuation plus $500 raised in dilutive financing multiplied by the new ownership percentage of 9.52 percent).

The Solution

Having the appropriate antidilution trigger will go a long way in maintaining the economic value of one’s investment. In the example given above, an exercise price or conversion price trigger, as opposed to a current market price trigger, would have been the more appropriate mechanism in order to preserve the economic investment. While the simplistic numbers used in the example above may appear harmless, the economic pain inflicted as a result of not having the appropriate antidilution trigger in a “real world” example can be significant.

However, an exercise price or conversion price trigger isn’t the panacea for antidilution protection. In fact, each of the antidilution trigger events described above (current market price and exercise price or conversion price) has strengths and weaknesses and, depending upon the circumstances, each independently does not adequately protect one’s economic investment. The solution is to have the antidilution formula keyed off of both trigger events. That is, there should be antidilution protection for issuances (or deemed issuances) of stock below the current market price and the exercise price or conversion price. The new exercise price or conversion price would be the lower price resulting from the application of both formulas. The use of both trigger events would solve each of the deficiencies inherent in both models.