6.2 Example: Venture Capital Transactions 291Investors can achieve anti-dilution protection in many ways. (a) There is no
standard anti-dilution protection. There are nevertheless some general models used
by venture capital firms. (b) Anti-dilution price protection can be a formula which
is applied to determine the number of shares issued upon a conversion. If the
company has issued convertible bonds or convertible shares, the conversion terms
can depend on the terms offered to new investors. If the company subsequently is-
sues securities at a price lower than that paid by the investor, more shares will be
issued upon conversion of the convertible bonds or convertible shares. Price-based
antidilution protection is thus accomplished by changing the conversion ratio and
by increasing the rate at which previously issued bonds or preference shares are
converted into common shares. (c) Anti-dilution price protection can become im-
portant, for example, after a negative change in the valuations of companies. The
two most popular methods are called weighted average and full ratchet.
The firm can try to dilute the terms of anti-dilution protection. (a) For example,
the firm can agree that the anti-dilution provisions: only apply for a certain period
of time; do not apply when shares are issued in transactions that are approved in a
specific manner (for example, by a majority of the class of financial investor pro-
tected by the term); and do not apply when shares are issues for fair value. (b)
Most agreements relating to venture capital transactions contain provisions that
permit the amendment of the venture capital agreements and the articles of asso-
ciation of the company with the consent of the company’s board and a specified
qualified majority of the investors’ votes. The purpose of such provisions is to al-
low changes in the documentation to be effected even if a minority of the investors
object. A large investor would therefore ensure that it has a share block that gives
it enough votes to block any changes in the articles of association.
Loans. The venture capital firm can also lend money to the company. The bene-
fit of debt is that it is repayable if the venture fails. The venture capital firm can
mitigate agency problems and increase potential return through convertibility. On
the other hand, the downside of debt is that the mere repayment of capital does not
enable the lender to profit from the success of the venture.
Equity kicker. This problem can be cured by using an equity kicker (see also
sections 6.3.8 and 20.7). For example, the venture capital firm can subscribe for a
convertible loan or be given share option rights. If the loan is a convertible loan,
the venture capital firm can: obtain control of the company when it turns out that
the company’s owner-managers do not perform as agreed; or increase profits
when it turns out that the venture is successful. The same objectives can alterna-
tively be achieved through share options.
There are alternatives to the equity kicker. For example, the parties may agree
on so-called tag-along rights of the venture capital firm in order to ensure that the
venture capital firm will be entitled to a share of the price paid for the company’s
shares when they are sold.