Price-based antidilution protection reduces the dilutive effect on an investor of a later financing at a lower valuation (a “down-round” financing). Price-based antidilution protection of some sort is a characteristic of most preferred stock and operates by increasing the number of shares of common stock into which a share of preferred stock converts (i.e. it increases the “conversion ratio”). There are two types of antidilution protection often found in angel and VC financings: full ratchet and weighted average.
Full ratchet antidilution adjusts the conversion price of outstanding preferred stock to that of the stock being sold in the new offering, thereby putting the existing investors in the same position they would have been in if they had purchased their shares at the new, lower price per share. This type of antidilution protection is extremely favorable to the investor and should be resisted by the company in favor of weighted average antidilution.
Weighted average antidilution reduces the conversion price of outstanding preferred stock in a proportionate manner taking into account both the number of shares being issued and the price per share. In this way the conversion ratio is adjusted to somewhere between the original ratio and the ratio that would apply after full ratchet antidilution protection. Weighted average antidilution may be either “broad” or “narrow” depending on whether certain derivative securities (such as options and warrants) are included in the calculation of the company’s existing capital, with a “broad” formula resulting in less dilution adjustment than a “narrow” formula.