TL;DR: If a tight fundraising market might mean a down round for your startup, you might be in for a painful squeeze. But at least Excel can help sort out the potential dilution.
Download the open-source cap table and the example spreadsheet.
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Unfortunately, although your blockchain-based frozen-banana delivery app is crushing it, you soon find you’re not immune from the overall downward trend in startup valuations in 2023. Your prospective lead Series B investor, Dr. Fünke’s 100% Natural Good-Time Family Venture Partners, knows it and is on the lookout for a favorable deal. This might mean a down round, and you’re curious about how that might affect the cap table.
Existing investors are concerned about down rounds for good reason. Optics aside, if a company sells a bunch of stock at a lower price than what the investors paid, that causes serious dilution to the original investors without adding corresponding value to the company.
The standard mechanism for dealing with this in venture deals (other than protective provisions allowing investors to block the issuance of additional stock) is called broad-based weighted-average anti-dilution protection. At a high level, this means that if a company issues stock at a lower price than what existing investors paid, the existing investors’ preferred stock is adjusted so that it is convertible into more shares of common – the more dilutive stock issued, the greater the adjustment.
The mechanics of, triggers for, and nuances around converting preferred stock into common are found in the company’s certificate of incorporation (charter) and can seem like mumbo-jumbo even to lawyers who don’t have a lot of experience in VC deals. They aren’t often heavily negotiated. As a result, lawyers, founders and investors alike tend to gloss over them in the documents, but it’s important to understand the way conversion ratios are adjusted if you are considering a down round. My expectation is that as VC money starts flowing again, we’ll see quite a few startups and lawyers dusting off their Excel skills for this reason.
The example spreadsheet shows one way to set up this model. The basic steps are as follows:
Step One: Model the Series B round the same way as you would for a Series A round. Include a pre-money valuation, an amount of new money coming in, and a target option pool size as inputs. Remember that the calculation of the option pool size (and the effect of the anti-dilution adjustment on the Series B price, as you’ll see below) requires circular calculations, so ensure that circular calculations are turned on with a sufficient degree of precision (10,000 iterations with a 0.00001 increment usually works).
Step Two: Build one anti-dilution model for each existing series of preferred stock that carries anti-dilution protection. In the example spreadsheet, that’s Series A-1 and Series A-2.
What we’re trying to find is the new conversion price for each subseries of preferred. The technical way to determine how many shares of common stock the preferred stock convert into is by multiplying the number of shares by the quotient of the “Original Issue Price” divided by the “Conversion Price.” In a standard venture deal, if your Series A Preferred was issued at $1.00 per share, the Original Issue Price is $1.00 and the initial Conversion Price is also $1.00. That’s 1/1, or one share of common stock per share of preferred stock. But if the anti-dilution mechanics require you to adjust the Conversion Price to take into account a down round, the Conversion Price might decrease to, say, $0.90. In that case, each share of preferred stock would convert into 1.0/0.9 shares, or 11.1% more shares of common (i.e., every 1,000 shares of preferred would be convertible into 1,111 shares of common).
How do you figure out what the adjustment should be? The answer is an opaque formula in your certificate of incorporation: CP2 = CP1 * (A + B) / (A + C). Breaking that down:
- CP2 is the new conversion price you’re trying to calculate.
- CP1 is the existing Conversion Price, so in this case the Original Issue Price.
- A is the number of shares of stock outstanding (assuming all warrants and options are exercised and all preferred stock is converted into common stock) immediately before the down round.
- Sometimes this number is negotiated to include the reserved but unissued option pool, which favors the common holders, or to exclude common shares issuable on exercise of warrants or options, which favors the investors.
- B is the hypothetical number of shares of stock (on an as-converted-to-common basis) that would have been issued if the preferred shares to be sold in the down round were issued at the existing Conversion Price (CP1) rather than the actual lower price. Divide the new money coming in as part of the down round by the existing Conversion Price.
- C is the actual number of shares of stock (on an as-converted-to-common basis) that will be issued at the lower price in the down round. Divide the new money coming in as part of the down round by the actual down-round price.
The example spreadsheet illustrates this calculation for both existing subseries of preferred stock, Series A-1 and Series A-2. Often, a down round will trigger anti-dilution protection with respect to a higher-priced subseries of preferred but not a lower-priced subseries, so it’s important to run the numbers separately for subseries of preferred with different original issue prices.
For the Series A-1, a $2 million Series B round at an $8 million pre-money valuation and a 10% post-money option pool (per-share price: $1.6154) reduces the conversion price from $2.5333 to $2.3267, which implies that each 1,000 shares of Series A-1 would convert into about 1,089 shares of common. For the Series A-2, the original issue price of $1.3500 does not change, which makes sense because $1.6154 is greater than $1.3500.
Note that the example spreadsheet contains a circular calculation to ensure that the conversion shares are included in the fully diluted pre-money capitalization used to calculate the Series B price per share, as discussed below. Before the circular loop is closed, the Series B price will appear higher.
Step Three: Using the new conversion ratios, build out the pro forma (hypothetical) Series B capitalization table. Add one Series B Preferred Stock (New Money) column to show the new shares and update the Total Stock columns to include those shares. To the right of each existing subseries of Series A Preferred, add a column reflecting the as-converted (common equivalent) shares, called Series [A-1][A-2] Common Equivalents in the example spreadsheet. Those columns should multiply the existing number of preferred shares by the ratio of the old conversion price to the new, rounded down to the nearest whole share.
The Total Stock (Outstanding) column and the Total Stock (Fully Diluted) column should both be updated to take into account the new as-converted numbers, as well as the new Series B numbers. That is because calculations of voting power and overall ownership are both based on as-converted numbers.
Step Four: Looking back to Step One, ensure that the Pre-money Capitalization number used to calculate the Series B price takes into account the new fully diluted share number (excluding, of course, the Series B shares themselves). Like the addition of option pool shares to the pre-money capitalization, this is a circular calculation. It is possible to negotiate a different outcome, but most sophisticated investors leading a down round will insist that the additional conversion shares resulting from the anti-dilution adjustment be added to the pre-money capitalization so that they do not dilute the new investors.
As with many elements of a VC financing, whether an anti-dilution adjustment happens at all is negotiable. Particularly if a round doesn’t have the vibe of a “real” down round to bail out a company in distress and the new price just happens to trigger anti-dilution because of how the round is structured (for example, if there’s a warrant sweetener or a large pool expansion artificially lowers the price), the affected series of preferred can simply waive their anti-dilution rights. The process for that is usually spelled out in the certificate of incorporation.
Lawyer note: This article covers only how to model a straightforward down round, and only the most common way to do so. It does not cover other types of anti-dilution protection such as “full ratchet.” Additionally, other issues relating to a down round, including possible structural alternatives, dealing with investor and market optics, repricing underwater stock options, fiduciary duties relating to financing approval, and generally managing stockholder litigation risk, are beyond the scope of this article. If there’s a possibility your company may need to go down this path, consult your trusty startup lawyer as soon as possible.
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