Startup funding may seem like a cut-and-dry affair. Money goes into a startup in exchange for shares in the startup. Easy enough, right?
Not so much.
There are plenty of complex terms, clauses, provisions and other conditions written into investment agreements. So in this series, “A Startup Takes Flight,” we’re exploring how some of the most common funding terms affect the fundraising process. To do so, we made up a company called the Internet of Wings, Inc. (abbreviated “IoW”) and followed its path.
We’ve previously worked through the basics of startup share structures. and common financial instruments used in seed deals, pre- and post-money valuations. In our second installment, we learned how pro rata clauses work and how to calculate the minimum investment required to maintain the same proportional stake in a company.
So far it’s been a pretty good run for our made-up company. It has raised money on decent terms. Here’s the capitalization table after Series B:
And here’s how the share structure broke down by stage after Series B:
However, on the suggestion of the board, it was decided that the company should undertake a strategic pivot; we’ll see how that turns out. In the process, we will learn about down rounds, share conversions and ratchet-based antidilution protections.
State of the Wing
It’s been a couple of years since Jill and Jack raised their Series B. However, executing such a pivot would prove to be expensive.
Their shift in strategy involved an expansion of their business away from simple drone-based delivery of chicken sandwiches. In order to be the drone-based logistics layer for all restaurants, they set up outposts in far-flung cities like Los Angeles, Boston and Austin, TX.
Inspired by gourds used to serve $14 artisanal yerba maté at a Mission District cantina they often frequented, Jack designed and began manufacturing a line of modular packaging that could contain everything from ramen to breakfast tacos. Remarking on the slightly oblong shape and white color of his containers, Jill joked: “I think we can finally answer the question. Chicken definitely came before the egg.”
It was not all smooth sailing, though. Minor hardware malfunctions resulted in dropped payloads. Most memorably, a class of slightly passive-aggressive elementary school students sent a copy of Judi Barrett’s classic Cloudy with a Chance of Meatballs to HQ after a drone accidentally dropped a party-sized egg of baked ziti as it flew over their playground at recess.
There were some bugs in the routing software, too. Skirting a little too close to LAX, a drone was taken out by one of the trained falcons otherwise tasked with dispatching birds before they get sucked into passing jet engines. A press photo showed the raptor nibbling steak tartare out of the drone’s payload. A long and drawn out investigation by the FAA ensued.
More seriously, the company found it surprisingly difficult to acquire customers. Takeout restaurants were hesitant to allow the drones with their hissing, squealing buzz fly near their businesses. Without the special bays and “Drone Zones” integrated into the Internet of Wings’s production facilities, more traditional restaurants found it difficult to integrate drones into their delivery workflows.
Tensions were also rising among the co-founders.
“I knew from the beginning that this ‘pivot and become a platform’ advice wasn’t good,” said Jack to Jill after everyone else went home. “You know they just wanted us to scale up so they can get a 10x exit on their investment, right?”
“There’s something definitely wrong here,” agreed Jill. “But there has to be a technical solution to customer concerns. Maybe we could put something around the rotors to reduce noise? Something soft, like feathers or some bio-mimicked material perhaps?”
Jack tried to remain calm. “Your proposed solution to our customer acquisition problem is to cover our drones, which no longer exclusively carry chicken, with feathers? Sounds like we’re running around with our heads cut off.”
We’ll check in on them in a bit.
IoW’s Series C dynamics
The Internet of Wings has not been living up to investor expectations. Raising, much less keeping, the $50 million Series B valuation was an order that got taller by the day.
In VC parlance, a “down” round is a financing round with a lower share price than the previous round. And in venture capital investing agreements, there are often a series of provisions included to protect investors from being diluted during down rounds.
As the name suggests, antidilution provisions protect previous investors from dilution in down rounds.
Like we discussed in the case of pro rata provisions, antidilution protections help investors maintain their proportional influence in a company. Things like board seats and votes are often allocated as a function of how much equity a given shareholder (in this case, an investor) controls. A shareholder doesn’t want that kind of influence snatched away from them by some other investor swooping in to buy up lots of cheap shares in a down round. This is one of the primary reasons for an investor to build in a price adjustment mechanism into their agreement with the company.
Back to our founders…
“Jack, stop it with the poultry puns. It’s getting really annoying and people are going to stop listening to you,” said an increasingly exasperated Jill. “But back to business, if we raised just a bit more money, maybe we could make this work? With another iteration on the drone technology, and a better on-site deployment strategy for our customers, we could be in the clear here.”
“IoW’s no spring chicken though,” said Jack, stifling a smile as he dropped another pun. “Given the slow growth of business, and the FAA breathing down our necks after the LAX incident, we’re not going to keep -- much less grow -- our $50 million valuation from our previous round, and that’s going to really, really suck for us. We’re going to be diluted down to nothing.”
“Not nothing,” said Jill. “But it’s still going to be tough. Look, we’ve got nine months of runway. After that, we’ve got nothing besides some drones, a few leases on some buildings, desks, laptops and a couple dozen employees who are going to be out of a job.” Jill, now appealing to the hungrier side of her co-founder’s psyche, offered, “If we stick this through, we can at least save this boondoggle and get something out of the years we’ve spent on this. It’s a slog, but it’s our slog.”
“You have no idea how much I want to fly the coop, Jill. But birds of a feather flock together, so we’re in this to the end, whether I like it or not. Guess we’ve got to call the board.”
Jill, Jack and the rest of the board collectively agree that Internet of Wings will need to raise another $10 million in a Series C round. This would be just enough money to sustain the company for another four to five quarters as it retrofitted its drones, worked with customers to regain momentum lost in the pivot and begin seeking exit options if the company failed to grow as expected.
Jack and Jill’s concerns came home to roost. Investors valued their company significantly below their previous $50 million valuation. Because of the regulatory pressure, sluggish growth and rumors that a major corporation is considering an entrance into drone-based delivery, IoW’s investors valued the company at $30 million pre-money. With roughly 27.5 million shares outstanding prior to the Series C financing, the company’s shares are now priced at roughly $1.091 per share (calculated by dividing the pre-money valuation by the number of shares outstanding prior to new financing), a change of negative 40 percent from the share price at Series B.
Before continuing, let’s digest some of the numbers related to this offering, because knowing how many shares are being created will be important for our antidilution calculations. To find the number of shares being issued, we simply divide the total amount of money being raised ($10 million) by the price at which shares are being offered ($1.091). The result of that simple arithmetic: we calculated that 9,165,902 Series C shares will be issued.
With that figured out, here’s the breakdown of what’s being invested in the round:
- Cormorant Ventures is investing $6 million for 5,499,541 Series C shares, 15 percent of the company, undiluted.
- BlackBox Capital is investing $4 million for 3,666,361 Series C shares, 10 percent of the company, undiluted.
- Provident Capital is not participating in the round.
But this is just the investment for this Series C round. Prior investors had antidilution clauses written into their investment agreements with the Internet of Wings. So let’s see how those terms affect the conversion price of extant Series B shares. Not sure what conversion price means? Fret not, because we’ll explain.
Antidilution terms from IoW’s Series B
IoW had three investors in its $15 million Series B round. The antidilution provisions worked out by each investor are as follows:
- Cormorant Ventures invested $10 million, and Provident Capital invested $1.5 million. Both negotiated a typical weighted average antidilution clause.
- BlackBox capital invested $3.5 million and negotiated a full ratchet clause.
There are two primary approaches to fulfilling antidilution clauses. The first, and perhaps most obvious one, is to issue new shares according to the type of agreement reached during the prior financing event. However, according to a highly referenced blog post by Brad Feld from 2005 on the subject, “it’s a silly and unnecessarily complicated approach that merely increases the amount the lawyers can bill the company for the financing.”
Rather, Feld and others suggest merely adjusting the price at which preferred shares can convert to common shares. In most startup shareholder agreements, preferred stock carries the option, but not the obligation, to convert to common stock. Typically, the ratio at which this occurs is one to one at the start, but it can vary.
However, in the event of a down round that triggers antidilution protections, this conversion ratio changes. How it changes depends on the type of antidilution clause written into an investor agreement, which we’ll discuss next.
In the case of Internet of Wings, the company will adjust the conversion price of its shares in the event of a down round. IoW negotiated “Pay to Play” provisions with each investor as a defensive measure. If previous investors don’t participate in the next round, Series C, they cede their antidilution protections.
How antidilution shakes out
In startup finance, ratchet-based antidilution provisions come in three main flavors, according to the NVCA’s model term sheet:
- Proportional / weighted-average antidilution protection
- Full ratchet antidilution protection
- No antidilution protection at all
Although these terms are presented from most common to least common, here we’ll approach them in reverse order because it’s easier to explain that way.
No price-based antidilution protection
It’s sometimes the case that the easiest way to explain how something works is to show what happens when it isn’t there. In our case, without any antidilution provisions in place, an investor bears the full risk of having their proportional stake in a company reduced, on an unconverted basis, in the event of a down round.
If the investor holds preferred shares without an antidilution provision, their shares will be diluted at the same rate as common shareholders, like pro rata but in the wrong direction. On one hand, this may feel fair and equitable to the founders, employees and other common stockholders -- because during a down round their investor is feeling the same dilutionary pain they are. However, to the investor a loss of relative influence within a company can, ahem, throw a wrench in their strategy.
For various reasons, Provident Capital didn’t participate in this round. Due to the Pay to Play provision, it’s not eligible to receive antidilution protection for its Series B investment. Its Series B shares will convert to common stock at a price of $1.818, the same price paid at the Series B round.
Math-wise, this is the simplest version of antidilution provision to understand.
According to the NVCA’s model term sheet, full ratchet antidilution means that during a down round, “the conversion price [of preferred shares from the previous round] will be reduced to the price at which the new shares are issued.”
Although BlackBox Capital’s Series B shares were originally issued at $1.818, and would have converted to common stock at that same price had IoW’s valuation not declined, BlackBox Capital’s Series B shares will now convert at the same price as the company’s Series C shares: $1.091. This allows BlackBox to receive 66 percent more common shares during the conversion of its Series B preferred shares. This 1.666x conversion ratio is derived by dividing the original issuing price of the stock ($1.818) by its adjusted price ($1.091) given to it because of the antidilution provisions.
Typical broad-based antidilution
Weighted average antidilution, unlike full ratchet protections, take into account a number of different factors to produce a more “fair” or reasonable dilution regime. It strikes a balance between the amount of money previously raised (and at what price) and the amount of money being raised in a down round (as well as the new, lower share price).
The NVCA’s sample term sheet includes a formula for the most common type of weighted average antidilution, a so-called broad-based weighted average.
Here’s the formula:
CP2 = CP1 * (A+B) / (A+C)
Now, for Cormorant Ventures, in order to find the conversion price of its Series B shares, we have to solve this formula for CP2, the new conversion price.
It’s not that scary. We already know these numbers, but they’re hiding behind some difficult legal language. Here’s how it translates in simpler terms catered to this specific case:
- CP2 = the Conversion Price in effect for Series B shares after Series C round is done. We have to solve for this.
- CP1 = the original Conversion Price for Series B shares. Series B shares were issued at $1.818 and would have converted to common stock on a one-to-one basis.
- A = the number of shares outstanding at Series B. There were exactly 27,499,998 shares outstanding prior to Series B.
- B = “The aggregate consideration received by the corporation” (i.e. the total amount of money invested in the Internet of Wings at Series C) divided by the original conversion price for Series B shares. Cormorant ventures is investing $6 million at Series C, and the original Series B conversion price was $1.818. B here equals $3,300,330.
- C = The number of shares being issued at Series C. As we discussed, there are a total of 9,165,902 shares being issued.
If we plug all those numbers into the equation and solve for CP2, we find that Cormorant Ventures’ Series B shares will now convert at $1.527. This is a 16 percent decrease from the original conversion price.
We can see here how the weighted average approach can seem fairer to both common shareholders (founders and employees, mostly) and other investors. Had Cormorant Ventures insisted on full ratchet protection, the firm would have been entitled to purchase shares at a much lower price, which would have resulted in a higher conversion ratio for them. Like we saw above, BlackBox’s conversion ratio was 1.666x. However, the conversion ratio for Cormorant Ventures is 1.191x. This weighted average method leaves more value on the table for both founders and other investors.
Share breakdown after Series C
In the Series C deal, $10 million was invested at a pre-money valuation of $30 million. With a share price of $1.091, the company is now valued at just a smidge over $40 million, with 36,665,900 shares outstanding.
In the past, we haven’t included a conversion price in our capitalization tables because preferred shares would convert to common shares on a one-to-one basis. But because IoW has now experienced a down round, this parity is now broken and we’ll have to include the conversion price. This also gives us the opportunity to calculate Internet of Wings’s ownership on an as-converted basis.
Here’s how it all breaks down now. Here is the capitalization table of the company presented as-is, without any conversions:
And here’s that same capitalization table, this time with ownership presented on a fully diluted basis:
Note how Cormorant Ventures’ stake in IoW’s Series B round went from 15 percent to 16.8 percent because of the weighted average antidilution provision. But we can really see the power of a full ratchet clause when we compare the unconverted Series B investment by BlackBox Capital to its fully diluted value. BlackBox’s stake 5.25 percent Series B preferred stake jumped to an 8.22 percent stake due to its full ratchet antidilution protection.
Here’s how the ownership of the company is divided by shareholder. Again, to show the difference between undiluted and fully diluted stakes, we’ve presented both here:
And here’s the company’s share structure -- presented on an as-converted basis -- after the Series C round is complete:
What we learned
In this installment of A Startup Takes Flight, we followed our co-founders through the trials and tribulations of raising a down round. Throughout this part of the funding process, we learned about the two main forms of antidilution protections: broad-based weighted average and full ratchet clauses. We also saw how Pay to Play provisions can protect founders from antidilution protections by exempting investors who don’t participate in down rounds.
Now, as we approach the final chapter, we ask ourselves how this is all going to turn out for Jill and Jack. Will their company rally and become a booming success and go public? Or will the looming threat of a corporate giant entering the ring force an early exit from the company? If the past three installments have been about investment, next week we’ll get to see what happens in the divestment process.