Securing Investors and Structuring the Deal 335Negotiable Terms to a Financial Agreement
Covenants and Provisions Protecting the Investment^1
Investors have a legitimate interest in protecting their investment. They do this by seeking cer-
tain rights in the financial contract, including cash flow rights, board rights, voting rights, liqui-
dation preferences, and control rights.^2 They seek to do this in various ways.
Antidilution provisions protect investors from having the investment’s value diminish if the
entrepreneur is forced to seek additional financing. It does not mean that the investors will never
suffer shrinkage of their ownership percentage. As long as any new stock is sold at a price equal
to or higher than the original investor’s conversion price, the original investor does not suffer
dilution. If the new stock is sold below the conversion price, the original investor loses econom-
ic value—unless an antidilution provision or “ratchet” is included.
There are two types of ratchets: full and weighted. A full ratchet is onerous for the entrepre-
neur because it requires that the original investor be able to convert all shares at the lower price.
In our example, the investor purchased 33.3 percent of the company for $1 million. If shares
were issued at $1 each, the investor would own one million shares. Suppose a full ratchet is in
effect and the company needs additional financing. Subsequently, it sells shares at 50 cents per
share. The conversion rate for the original investor will drop to 50 cents. The 1 million shares
become 2 million shares. If 250,000 50-cent shares have been sold, the total value of the shares
outstanding is now $4.125 million (the entrepreneur’s $2 million, the original investor’s $2 mil-
lion, and the new investor’s $125,000). But the original investor’s percentage of ownership has
risen to 48 percent (2 million shares divided by 4.125 million shares). Over time and in case of
financial crises, full ratchets severely reduce the value of the firm to its founders and their share
of ownership.
The weighted ratchet is fairer to the entrepreneurs. The conversion price is adjusted down by
the weighted average price per share outstanding. The formula is:
X = (A x B) + C/(A + D)
where
X = new conversion price
A = outstanding shares prior to the sale
B = current conversion price
C = amount received on sale of new stock
D = number of new shares sold
To illustrate from our example, if:
A= 3,000,000 shares
B= $1.00
C =$125,000
D= 250,000
then the new conversion price for the original investors is $0.9615, not the fully ratcheted $0.50:
(3,000,000 • $1 00) + $125 000
3,000,000 + 250 000 = 0 9615APPENDIX C