Unless you’re one of the lucky few who start and take a company public in an IPO, the other option for a successful “exit” from that business is to sell it. This exit opportunity is especially important for startups that raise venture capital. VC’s are duty-bound to return capital back to their investors, and hopefully with more than they started with.

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However, the market for startup equity isn’t very liquid. Unlike the public stock market, where investors can liquidate their positions in a fraction of a second, VCs usually have to wait years for a liquidity event. How that process works – the actual deal-making and negotiating – is a bit beyond the scope of what we can do today, but here we’re going to take a look at how the money shakes out of a company.

This is the fourth and final installment in a series called A Startup Takes Flight. We started by making up a company – the Internet of Wings, a provider of drone-delivered chicken sandwiches that’s since pivoted into general food delivery – and examined some of the most common financing terms entrepreneurs and VC investors discuss.

In the first installment, we looked at the basics of SAFE notes and how they convert to equity with terms like discounts and valuation caps. Then, in the second installment, we saw how VC investors use pro rata terms to maintain their proportional ownership in a startup. In the third, we learned what happens when growth markers aren’t hit, and saw how full ratchet and broad-based anti-dilution protections come into play when a company raises a down round.

It is now time to get our fictitious investors a liquidity event from our little drone startup. Let’s sell our company!

Liquidity Event Dynamics

There are a number of terms connected to the sale of a startup, and in this section, we’ll explore the two most important ones. By looking at liquidation preferences and seniority structures, we get an understanding of how much money a shareholder is entitled to and when they’re able to get it.

Liquidation Preferences: Participating vs. Non-participating Stock

As we’ve mentioned in earlier installments of this series, startup investors receive so-called “preferred” stock, whereas employees and founders receive common stock. Preferred shares can carry a number of rights and privileges to which mere commoners aren’t entitled – like anti-dilution protections, voting rights, and claims to board seats, among many others – but perhaps most important to the discussion of liquidity events, preferred shareholders can receive what are known as “participation rights.” Terms like “participating preferred stock” and “non-participating preferred stock” refer to whether investors receive these rights, and we’ll get into what these terms mean here.

In short, participating preferred shareholders are entitled to receive their initial investment, plus a pro rata share of the remaining capital in a liquidation event. Here’s a simple example to illustrate this. Let’s say we have a company, Acme Inc., and it has received $20 million in investment for participating preferred shares, representing 20 percent of the company’s capital structure on an as-converted basis. (Common shareholders account for the remaining 80 percent.) Acme Inc. is later sold to another company for $80 million in cash. Those participating preferred shareholders not only recoup their $20 million, but they’d also be entitled to 20 percent of the leftover proceeds of the sale, an additional $12 million in this case. (20% * ($80 million from the acquisition – $20 million already returned to participating preferred shareholders)) So participating preferred shareholders in Acme Inc. would get a total of $32 million back, leaving just $48 million for common shareholders.

This is why participating preferred shareholders are sometimes accused of double dipping, precisely because they take two slices of the capital pie. It’s important to note that there are a few clauses that can serve to limit the financial impact of participating preferred shareholders, such as capping the amount of money they can take from the remaining proceeds.

Non-participating preferred shareholders, on the other hand, don’t get this opportunity to double dip. They are only entitled to either their initial investment amount or their pro-rata share of proceeds from a sale. (Note that, depending on the deal terms, investors can be entitled to a multiple of their initial investment, but the overwhelming majority of VC deals carry a 1x or smaller liquidation preference.)

In the previous example, had Acme Inc’s investor been a non-participating preferred shareholder with a 1x preference, they’d be entitled to either the $20 million they invested, or 20 percent of the $80 million sale ($16 million in all). In this case, they would take their $20 million back, leaving $60 million to be distributed to Acme Inc.’s founders and employees.

In these two contrasting examples, it’s easy to see why non-participating preferred stock arrangements are more favorable to startup founders and employees; it leaves more money on the table for them. That’s why issuing non-participating preferred stock is the standard practice for most technology startups. According to the most recent from Cooley, a major Silicon Valley law firm, over 80 percent of the VC deals struck in Q2 2017 had no participation rights attached. However, what holds true for technology doesn’t hold true for startups in other sectors. Most notably, participating shares are standard-issue in life science venture capital deals, a topic by Atlas Venture partner Bruce Booth in 2011. Crunchbase News confirmed that this is still the case with a current life sciences investor.

There’s one last question that’s important to address here: what happens if the proceeds from liquidation don’t cover the preferences investors are entitled to? To refer to our examples above, what if Acme Inc. sold for less than $20 million, which would mean non-participating shareholders wouldn’t be covered? Or, for those double-dipping participating shareholders, what if the company sold for less than $32 million? In both of these cases, shareholders would convert their shares to common stock. They would then receive a proportional share of the proceeds alongside other common stockholders.

Seniority

Besides liquidation preferences, the other term that has the greatest bearing on the liquidation process is seniority. Basically, it describes a stakeholder’s position in the line to get their money back. The closer to the front of the line you are, the more likely you’ll be able to get what’s owed to you in the event of the sale or bankruptcy of a company.

In the “big picture,” creditors are senior to shareholders, meaning that the company will first have to repay its debts before its shareholders can cash out. Within each type of stakeholder – again, creditors and shareholders – there can be many different tiers, but here we’ll focus just on the seniority structure of shareholders.

One of the other privileges given to preferred shares is seniority to common shareholders, so in the event of an acquisition or bankruptcy, preferred shareholders – the investors – get access to proceeds from that liquidation event before common shareholders (founders, employees, and service providers to the company).

But not all preferred shareholders are necessarily created equal. Depending on the seniority structure, some investors are closer to the front of the line than others. The two most common seniority structures are the “standard” approach, and what’s known as pari passu. Let’s take a look under the hood, shall we?

In the standard approach, seniority is ranked in a sort of reverse chronological order. It’s a “last in, first out” situation. Investors in the most recent round – in the case of Internet of Wings Inc., it’d be the series C preferred shareholders – are the first in line to receive their payouts, whereas investors from earlier rounds will have to wait their turn. This can lead to a situation where, if the company was liquidated for a very small amount of money, earlier investors, and common stockholders, get nothing. But that’s how it works.

Lee Buchheit, a legal expert specializing in debt crises, the pari passu clause as “charming.” The term, according to Buchheit, is “short, obscure, and sports a bit of Latin; all characteristics that lawyers find endearing.” Translated literally, it means “with an equal step,” and in the case of financial seniority, it basically means that there is no seniority. For preferred shareholders, it means there is no orderly queue, which may sound like a bad thing. But it allows all involved investors to gulp down their liquidation preference payments at once, with Seed preferred shareholders getting the same access to a payout as Series D investors.

As an aside, these are not the only two ways to structure financial seniority. There’s also a hybrid approach where investors are put into different tiers of seniority but, within each tier, liquidation preference payments are distributed pari passu.

And before we see how these terms affect how money is returned to shareholders, let’s quickly check in on our company.

State of the Wing

It’s been a little over a year since Jill and Jack raised a down round at Series C to keep funding their enterprise.

Despite a somewhat rocky start and a thin budget, the duo and their team managed to turn what was a failing business into, well, not exactly a raging success. However, it was something they didn’t feel shame about. After all, their struggles had been loud and public.

To that end, they worked tirelessly to make their drones quieter. After all, it was the noise that scared most of their customers, consisting mostly small restaurant owners looking for a better, faster delivery method, away.

It turns out that Jill’s earlier idea of using feathers to reduce noise wasn’t so cockamamy after all. After consulting with a food safety expert, though, they realized that using actual feathers would get them into even more hot water with the government. It took over a year to settle the case with the FAA after the steak tartare incident at LAX.

In an after-work meeting at that Mission cantina Jill said, “We don’t need the FDA, USDA, or whatever alphabet soup agency that deals with this sort of thing on our case again. Feathers are out.”

“You mentioned bio-mimicked material before. Owls have these super fluffy feathers on their, uh, undercarriage that help them stay deadly silent. I have an ornithologist friend who moonlights as a material scientist. We could get him to develop some proprietary fluff for us.” Jack offered.

“Give him a holler,” said Jill. “No use in chickening out now.”

After months of tweaking and testing, this improbable combination of bird scientist and polymers aficionado had developed a material that was uniquely suited to the task of reducing the drone of the drones. It had the added benefit of making the engine housings appear to be covered in thick white down, which went a surprisingly long way toward relieving customer anxiety over sharp, whirling propellers.

Meanwhile, the little drone startup that could had caught the eye of a corporate development executive at Sahara, and she kept that eye on our startup for the past several quarters.

We all know Sahara, the online shopping conglomerate that’s metastasized into other industries ranging from infrastructure and abortive attempts at phones, to grocery and food delivery. Its founder desired to build an ecosystem wider and deeper than any rainforest, aspiring to offer more products and services than there are grains of sand in the wide, desolate expanse of north Africa. And, for most intents and purposes, that’s what Sahara has achieved. But like the slow, creeping spread of the real Sahara desert, the company managed to keep adding more products and services. And the next one was drone delivery.

The Sahara executive was intrigued by the team and the Internet of Wings’s adoption by real, brick and mortar businesses. Indeed, it was brick and mortar businesses that the company had successfully competed against for years, so much so that restaurants, coffee shops, bars, and other foodservice businesses seem to be the only ones left. But it was that market – restaurant delivery in particular – in which Sahara had not yet found a toehold.

The Internet of Wings, she thought, would be that foot in the door.

Sahara’s offer – $75 million to buy IoW’s business, the drones, intellectual property, and the services of its team for the next three years – was not the first acquisition offer Jack and Jill had received, but it was the best. And considering that they’d raised a Series C round explicitly to fund the company as it found a final resting place, taking the offer was aligned with their original plan.

Put to the board in a hastily-called meeting, the decision to accept Sahara’s offer was approved.

The Deal

Internet of Wings Inc.’s board decided to accept Sahara’s offer to buy the entire company for $75 million in an all-cash deal.

Here’s the clauses of the Internet of Wings’s investment agreement that will be important for this transaction:

• As is common practice in tech startups, investors’ preferred shares were non-participating.
• Seniority is standard (last in, first out).
• All outstanding options will convert to common stock during the liquidity event.
• From the Seed round through Series B, investors had a 1x liquidation preference, but due to the adverse conditions the company had experienced leading up to its Series C round, investors in the Series C round received a 2x liquidation preference.
• We’re assuming the company has zero debt and no dividend rights. We’re going to make this as vanilla as possible.

To illustrate the process more clearly, we’re going to show how each investor decides how they approach the choice between taking their liquidation preference payment or converting to common stock and redeeming their proportional share of the proceeds available to investors in their seniority level. And for each seniority level, we’ll plot how much of the $75 million acquisition they received.

We start with the most senior investors. Since Internet of Wings’s most recent financing round was a Series C, shareholders of Series C stock are most senior.

In this case, because series C shareholders attached a 2x multiple to their liquidation preference, they will get more money by taking the liquidation preference payout than by converting to common shares. Cormorant Ventures receives $12 million (twice its investment in the round) and BlackBox Capital receives $8 million (again, twice its investment in IoW’s Series C round).

Series B and earlier shareholders only have a 1x multiple on their liquidation preferences, and we’ll see how that affects decision-making.

In this case, it makes more sense for the Series B shareholders to simply take back their initial investment, rather than converting to common common shares, and we’ll notice that this is a pattern. Cormorant Ventures collects its $10 million; Provident Capital takes its $1.5 million, and BlackBox Capital receives its $3.5 million. At this point, almost half of the $75 million paid out in the acquisition has now been accounted for.

Moving down the seniority ranks, we now have our Series A shareholders, which also have a 1x multiple on their liquidation preference.

Here too it makes more sense for investors to take back their initial investments according to their liquidation preferences.

It’s in the case of the two participants in the seed round that things get marginally more interesting, but – spoiler alert – it will still make more sense for them to take back their initial investments.

Here’s why it’s interesting: both investors in the seed round committed $2.5 million, and as we showed in the first installment of this series, the terms of a seed deal matter quite a bit. BlackBox Capital opted to go with a valuation cap, while Opaque Ventures were able to buy shares at a 20 percent discount. Because of IoW’s series A valuation and how that round closed, BlackBox came out ahead in the round, both financially and in terms of proportional ownership of the company.

So what is left? As it turns out, quite a bit. After all of the preferred shareholders cashed out, common stockholders get whatever is left.

Despite all of the trials and tribulations of getting the company started, it looks like it was all ultimately worth it, at least for our founders. Here, as the last recipients of proceeds from the acquisition, final payouts are determined based on ownership ratios in the company. Since Jill holds approximately 48 percent of the remaining stock, she gets that share of the heretofore unallocated $26,125,009.50. Jack, holding roughly 32 percent of the remaining stock, gets 32 percent of the remaining proceeds. And employees receive a collective bonus of 20 percent of the remaining capital.

Investor Performance

One of the most common measures of performance in the VC space is also one of the simplest. Calculating the multiple on invested capital (MOIC) is as easy as dividing the amount of money received after the company winds up by the total amount of money invested.

So, as we can see here, Internet of Wings Inc. was not a home run. Silicon Valley investors talk a lot about finding the companies which will deliver a 10x return on the capital they invested, and IoW didn’t achieve that for its shareholders.

Although “price matters” may sound like the most painfully obvious statement ever, price really does matter, but not for an immediately obvious reason. Remember that preferred shareholders carry the option to convert their shares to common stock and receive their proportional share of the payout. That conversion threshold – the proceeds from a liquidation that would make common shares more valuable than simply the liquidation preference payout – is different for each set of shareholders, and it depends on the terms of the deal. In the case of Internet of Wings, for every single investor to convert to common shares, the company would have to sell for about $118 million.

Here’s the approximate conversion thresholds for the other shareholders, rounded up to the nearest $1 million increment:

• Series C – $73 million.
• Series B – $104 million.
• Series A – $117 million.
• Seed – $118 million.

That’s why Series C shareholders were the only ones that had any incentive to convert their shares, because the $75 million in proceeds from the sale was above that conversion threshold. (And, for the record, if IoW sold for anything less than about $48.9 million, Jack, Jill, and their employees would have gotten nothing from the acquisition of the company.)

What We Learned

Obviously, every deal is different, but the principles remain the same. Professional investors are in the business of generating returns for their limited partners. It’s difficult to predict how an investment is going to work out until it works itself out. But as we’ve shown here, that working-out process doesn’t need to be difficult. It’s just a series of rational decisions based on what will generate the highest return on investment.

We looked at the effect liquidation preference multiples have on investor decision-making and how a standard seniority structure works during an acquisition. And, we’ve learned the all-important nature of price, both to returns, and to investor decision-making.

Throughout this series, we’ve shown that the mechanics of startup finance are not that confusing or opaque. Although we used deliberately simple examples, the “real world” isn’t that much more complex. Of course, there are way more legal terms than the ones we’ve discussed throughout the series, but we selected terms like liquidation preferences and pro rata because they have the greatest bearing on the financial outcome of a company. For all the other covenants, clauses, and contractual agreements, find a good lawyer and get venturing.

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.

�±�’v�� 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 cofounders.

“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 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 9 months of runway. After that, we’ve got nothing besides some drones, few leases on some buildings, desks, laptops, and couple dozen employees who are going to be out of a job.”Jill, now appealing to the hungrier side of her cofounder’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.”

The Round

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 out 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. Due to 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 forty 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, fifteen percent of the company, undiluted.
• BlackBox Capital is investing $4 million for 3,666,361 Series C shares, ten 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 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 “” 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 :

1. Proportional / Weighted-average antidilution protection
2. Full Ratchet antidilution protection
3. 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 ratabut 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..

Full Ratchet

Math-wise, this is the simplest version of antidilution provision to understand.

According to the , 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 sixty-six 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 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 of 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 sixteen 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. Now, 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 due to 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 now 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 cofounders 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.

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To do so, we’re following two entrepreneurs who started a company and raised some money from investors. The people, company, and funds involved are fictitious, but the math and deal terms are very much real.

After covering the basics of founding a company, dividing up founder shares, capitalization tables, the common financial instruments, deal terms used in the Seed funding process, and how those deal terms affect pre- and post-money valuations.

This week, we’ll see what happens when Jill and Jack raise their Series B round.

For the sake of our story here, what happens during the Series B round will illustrate two of the other primary levers of power venture capitalists can negotiate into their investing agreements with their portfolio companies. What follows is our best attempt at making the topic of “pro rata rights” approachable and, with some luck, fun. (And this will tee us up for a discussion of “ratchet-based antidilution protections” next week.)

A Quick Reminder of Where We Left Off Last Week

Here’s a quick recap of the key facts from last week:

• Jack and Jill are cofounders. Jill is CEO.
• They started a company called Internet of Wings, which they’ve taken to calling IoW.
• IoW does drone delivery of house-made chicken sandwiches throughout Silicon Valley with aspirations of expanding beyond the Bay Area.
• IoW raised an unpriced seed round and a $7 million Series A round at a $15 million pre-money valuation, and a $28.87 post-money valuation due to the terms of the Series A deal.

Here’s the company’s full capitalization table from where we left off last week, after Internet of Wings raised its Series A.

And here’s where the company’s share structure as of their Series A round.

Let’s see what happens when a new round of financing comes in.

Series B Dynamics

In overused Shakespeare quotes, college writing classes, , and venture capital deals, “what’s past is prologue.”

In most cases, a startup’s fundraising history sets the trajectory for future investment. There are many deal terms that affect which investors can get in, how much stock they’re able to buy during a funding round, and at what price they buy those shares. But here, we’re focusing on two: pro rata rights and pre- and post-money valuation.

Pro Rata Rights

One thing to note about venture capitalists and lawyers: they tend to use lots of Latin phrases, pro rata included. Literally translated, it means “according to the rate,” but for all intents and purposes it’s come to mean “proportionally” in both venture capital and other branches of finance and law.

In venture capital, a pro rata clause in an investment agreement gives the investor a right (but not the obligation) to participate in one or more future financing rounds to maintain their percentage stake in the company. One of the more cogent explanations of how pro rata affects investor dynamics comes from Fred Wilson, a well-known venture capital blogger and managing partner of New York-based Union Square Ventures. , he gives the following example:

“You invest $50k in a seed round at a $5mm cap and own 1% of the company. The next round is a $3mm round at $9mm pre, $12mm post. If you don’t participate, you will be diluted 25% and will then own 0.75% of the company. On the other hand, if you buy 1% of the round, a $30k investment, you will continue to own 1% of the company. Your ‘pro-rata right’ in this situation is a $30k allocation in the next round.”

For all investors, these clauses are a risk management strategy, in that they add a layer of predictability to a generally unpredictable asset class. Especially for angel and seed investors, they guarantee a seat at the table during a Series A round. For other investors, pro rata clauses allow them to maintain percentage positions in their most successful portfolio companies as those scale.¹ And for those companies where maintaining a certain percentage ownership stake is a requirement for keeping a board seat, pro rata rights help investors maintain that type of oversight.

For entrepreneurs, though, pro rata rights can be a bit of a double-edged sword. On the one hand, pro rata rights help to answer the question “who’s going to invest in the next round?” However, the clause is one of the main reasons why founders must be choosy with their early investors, if at all possible. Friendly seed investors or venture capitalists that add a lot of value to the company and make introductions and provide strategic guidance like it’s their job (because, well, it is) are the sort of folks that founders want to maintain influential equity stakes in their companies. If given pro rata rights, those investors who don’t add value beyond the check they signed, or have ulterior motives for investing in the company can shut out the good ones from a round.

The State Of The Wing

Catching up with our two intrepid cofounders, Jack and Jill, the business has been growing at a decent clip. It started as a cockamamy idea hatched over dinner at an uppity cantina in the gentrified side of San Francisco’s Mission District. It was, after all, an elaborate pun of a business idea at the outset, but it caught on and expanded in scale, if not quite yet in scope.

“The state of the Wing,” Jack proclaimed in his worst Obama impression, “is strong.”

The Internet of Wings now has a custom facility with a kitchen, packaging line, and a hive of custom sandwich-delivering quadcopters Jill has affectionately dubbed “The Drone Zone.” Granted, it’s still just a couple of rooms hacked out of a defunct Pizza Hut near South San Francisco, but for a Series A-stage company, Jack and Jill feel like they’re doing well.

IoW has some revenue and a small, but very loyal, base of customers mostly consisting of college students and tech startup employees. The value proposition to them: the novelty factor of air-dropped chicken sandwiches, plus the cost savings of not having to pay a gig economy worker to wait in line and listen to podcasts. And an Area Venture Capitalist has even made it a Thursday tradition to have a sandwich delivered through the sunroof of his Tesla Model S amidst the gridlock on Route 101. His Snaps reviewing the food and experience have all twelve tech journalists that care about this sort of thing atwitter on Mastodon.

In order to continue this hockey stick growth, Jill, Jack, and the other board members decide that the company should raise a Series B round. The board encouraged a slight pivot in strategy, from what one member characterized as “a full-stack, on-demand delivery restaurant” to a generalized drone delivery platform for local restaurants in the Bay Area.

“Think of it like this, Jill,” BlackBox Capital’s Dirk V. Snodgrass Jr., relayed in an email after the meeting, “Internet of Wings can be an end-to-end service provider, a deployment solution for on-prem consumption of calories-as-a-service.”

Pro Rata Rights in The Internet of Wings, Inc.

Before we get into the math behind this particular round, let’s look at IoW’s investors and their pro rata rights.

• BlackBox Capital has pro rata rights on its 3.46 percent Series A stake, but not its Seed stake
• Provident Capital has pro rata rights on its 6.93 percent Series A stake
• Cormorant Ventures has pro rata rights on its 13.85 percent Series A stake

Again, these investors have the right, but not the obligation, to invest proportionally in Internet of Wings’s Series B round.

Internet of Wings’s Series B Round

Backstory

Jill, Jack, and the board decided to raise a Series B round to fund continued expansion of the Internet of Wings’s operations in the Bay Area and development of a platform for other restaurants to deliver their food via drone to hungry customers.

Jack and Jill, sitting at the same shabby, chic cantina where they came up with the Internet of Wings in the first place, decided to pursue this new direction.

“It was never about the chicken sandwiches,” said Jill to Jack, who seemed somewhat crestfallen at this admission. Jack, after all, had the food science background and had successfully recreated the sandwich he remembered from his youth.

Jill continued, “I mean, like, the total addressable market of food delivery is ginormous. Billions of dollars a year.” She looked at her phone and pulled up a chart one of the board members sent her.

“Real-time follow up!” exclaimed Jill, “Tens of billions a year within the next year or two. If we’re able to do this, we won’t just be the internet of chicken wings and sandwiches… we could be the logistics layer for the calories-as-a-service industry!”

“You’re sounding like Dirk,” said Jack.

“Look, let’s try this. �±�’v�� got the drone tech down. �±�’v�� only dropped payload a couple of times. The limiting factor here is that we want to be an end-to-end foodservice business. And, to be honest, I’m having a hard time giving a cluck about chicken sandwiches. Jack, you’ve got the packaging science down… why not harness those talents for other kinds of food?”

Jack took a deep sip of his $14 artisanal and looked down at the gourd it was served in. He admired it for a second, focusing on its natural insulating properties, the fact it was biodegradable, and the fact that drinking vessels could literally grow on trees. “OK let’s do it,” Jack said as he snapped the clamshell to-go container.

The Deal

Cormorant Ventures, the lead investor from Series A, takes the lead on Internet of Wings’s Series B round as well. Analysts and partners at the firm were impressed with the traction of Jill and Jack’s company, and they found the new platform direction compelling. They took the firm’s current revenue and book of business into account, its proprietary drone technologies, and the engineering talent the company was able to recruit to date. All in, they’re valuing Internet of Wings at $35 million pre-money, a 21.2 percent step up from the company’s $28.875 million Series A post-money valuation.

In this round, IoW is looking for a $15 million cash infusion to continue building out its flock of drones, a spot market for its drone services, a new packaging design lab, and a few test hives (“Drone Zones,” internally) with bays for more drones.

Unlike with the Seed round, there were no discounts, valuation caps, or other deal terms attached to the Series A round that would create a higher valuation for the company at Series B. So, here, the post-money valuation of the company is going to simply be the sum of its pre-money valuation ($35 million) and the amount of money being raised in this round ($15 million), a total of $50 million post-money.

How Pro Rata Works

Recall that after Series A, the company had approximately 19.25 million shares outstanding. To find the share price at Series B’s valuation, we divide the pre-money valuation ($35 million) by the number of shares outstanding just prior to Series B (19.25 million) to arrive at a share price of approximately $1.818.

So, if Internet of Wings is raising $15 million, that means the company will need to issue $15 million worth of stock at a share price of $1.818 per share. When all is said and done in this round, the company will create 8.25 million new shares.

Now, calculating the amount that each investor must invest in the round to maintain the same percentage ownership is simply a matter of multiplying their percentage stake prior to the round times the number of new shares being issued in this round, and in turn multiplying that by the current share price.

So, at minimum, given the current share price and the number of shares being issued in the round, Internet of Wings’s previous shareholders would have to invest approximately:

• Cormorant Ventures – $2.077 million
• Provident Capital – $1.04 million
• BlackBox Capital – $519,000

Investment And Ownership After Series B Deal is Done

In this case, because the company’s valuation hasn’t increased by a huge amount and the company is raising a sufficiently large amount of money in this round, all investors are able to participate and maintain their pro rata stakes.

In this round, Cormorant Ventures invests $10 million of the approximately $15 million total round. Provident Capital invests $1.5 million, and BlackBox Capital fills out the rest of the round with an investment of $3.5 million. (So, to clarify, Cormorant Ventures had to put in a minimum of $2.077 million to maintain their 13.85 percentage stake from the previous round. By investing the additional $8 million, they grew their percent stake in the company to roughly 32 percent.)

Here’s the capitalization table of Internet of Wings after its Series B round is complete.

And here’s the company’s share structure.

And here’s where the company’s various shareholders sit with respect to one another.

What We Learned

This week, as we followed Jill and Jack through the process of raising their Series B round, we learned about pro rata, one of the most important clauses in a venture capital investment agreement because it ensures that investors aren’t diluted in a subsequent of financing round. We also learned how to calculate how much an investor needs to invest to maintain their ownership stake in the company.

The question is, will Jack and Jill’s new vision of building a generalized transportation layer for restaurant delivery work? Rocky times may be ahead, so tune in next week as we learn about ratchet-based antidilution protections and what happens during down round financings.

Footnotes

1. This is part of the reason why there are an increasing number of so-called “opportunity funds,” which give venture capitalists and their limited partners more exposure to the late-stage rounds of their early successes.

Illustration:

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When you’re first starting out (or just need a refresher), it’s often best to learn from examples. So, that’s what we’re going to do today. We’re going to explain the basic mechanics of the first rounds of funding, some of the key terms involved, and how different types of financial instruments and deal structures work. Let’s start a company and build a capitalization table! And, for the sake of keeping this accessible, we’re going to try to keep the terms simple.

(Also note: all companies and funds mentioned in this article are fictitious and presented for the sake of example. Any resemblance to real firms is purely coincidental.)

Founding A New Company

Let’s start at the beginning. Imagine two founders, Jack and Jill. Their idea: The Internet of Wings, a buffalo chicken restaurant featuring drone delivery to all of Silicon Valley and beyond.

They work with a lawyer to set up a corporation. The two decide to split their stakes at a 60-40 ratio, with the majority going to Jill because she’s going to serve as CEO and has the technical background to make the scalable part of the business – drone-based delivery – a reality. They also decide to set aside 20 percent of the shares in an equity pool for future employees. So, here’s how the ownership stakes break down at the start:

• 48 percent to Jill
• 32 percent to Jack
• 20 percent for an employee pool

Internet of Wings Inc. (abbreviated IoW, like IoT but involving poultry) was established as a Delaware C corporation – the standard type of legal entity for venture-backed startups – with 10,000,000 shares of Common Stock outstanding, issued at a par value of $0.001 per share. With this, in the eyes of the law, the company is now valued at $10,000. Here is the capitalization table for the company at this point:

Jack sets to work developing a chicken sandwich that appears to be lovingly hand-crafted, even when produced at industrial scale. And he may or may not have taken “inspiration” from Apple’s when creating packaging to keep the sandwiches intact and warm, but not soggy, during the short airlift from IoW’s rented kitchen space to the customer. Meanwhile, Jill hacks together a drone capable of flying chicken sandwiches hither and yon.

After months of working nights and weekends, they go to a park – their Kitty Hawk – and successfully make their first flight, which was captured on video and subsequently went viral on Periscope. With demonstrated demand for the novel idea but no cash to cover the costs of the business, Jill determines it’s time to raise some outside capital in a Seed round.

Seed Round Dynamics

Seed rounds come in two main flavors: priced and unpriced. A priced Seed round is much like any other round of funding in that the company is given a valuation, and shares in the company are purchased for cash by investors at a price determined by that valuation.

But today, due to their popularity relative to their priced cousins, as well as their unique structures and financial instruments, we’re going to focus on unpriced seed rounds in this section.

As the name suggests, in an unpriced round, the company is not given a valuation, and the investor isn’t necessarily purchasing a known amount of equity at the time of investment. Rather, it’s an agreement between the investor and the company to issue shares in a future, priced round in exchange for an infusion of cash at the time the unpriced Seed deal is struck.

The two most common financial instruments used in unpriced seed rounds are convertible notes and so-called Simple Agreements for Future Equity (or “SAFE notes”). A convertible note is a financial instrument that is issued first as debt, but then converts to equity under predetermined conditions, such as raising a priced round. A SAFE note is like a convertible note, except it’s not a debt instrument, meaning that SAFE notes don’t carry an obligation to pay interest. by Y Combinator, the prominent Silicon Valley-based incubator program, SAFE notes are generally thought to be more founder-friendly than convertible notes precisely because they aren’t treated like debt, so they don’t have a maturity date or interest payments associated with them. And as an added point of convenience, the agreements tend to be short, and there are comparatively fewer terms for founders to negotiate.

Risk Management

Because Seed investors take on a lot of risk by investing in very early-stage companies, they’ll oftentimes add a number of provisions to their investment agreements to ensure they get a sufficiently large piece of the company to justify that risk. Two of the most common provisions in unpriced rounds are “discounts” and “valuation caps.”

True to its name, a discount provision grants investors the right to purchase shares at a discount from the price of shares in the next funding round. In this case, the next round is Series A, which is typically the first priced funding round a company experiences (and the point at which the convertible note or SAFE would convert to shares). Separately, a valuation cap puts a ceiling on the valuation of the company such that the investor can ensure they get a certain percentage share of a company. This helps to prevent a runaway valuation from squeezing the percentage share they’d be able to purchase in the company.

The Seed Deal

Back to Jack and Jill. They decide to raise capital in an unpriced Seed round for their startup. They figure they need to raise $5 million to get their company off the ground. After soliciting introductions from their network, and lots of back and forth, they find two investors eager to commit the entirety of the round.

Opaque Ventures agrees to a $2.5 million SAFE with a 20% discount provision, and BlackBox Capital will invest $2.5 million in a SAFE that has a $10 million valuation cap on the company’s pre-money valuation. Agreements are signed, money is wired to the company’s bank account, and Jack and Jill resume the process of building their venture.

It’s important to note that, at this time, no new shares have been created, and the value of the company remains the same because, again, this is an “unpriced” round where no new value is assigned.

Series A Dynamics

Fast forward 18 months. Business is booming, with a fleet of drones buzzing all around the Bay Area delivering chicken sandwiches to hungry customers. Jill and Jack have marshalled the financial resources from their Seed round well, having invested heavily in R&D, a few good engineering hires, and a few agreements with drone manufacturers overseas. But despite rapid growth, the company isn’t profitable and only has eight months left before it runs out of cash.

It’s time to raise a Series A round. If a company hasn’t already raised a priced round, Series A is typically when the shares of a startup receive their first valuation.

Amongst venture capitalists and other startup investors, it’s common to hear two types of valuations mentioned: “pre-money” and “post-money.” Put simply, a pre-money valuation is the value of the company prior to (hence “pre-”) the round’s infusion of capital. The post-money valuation is the value of the company after the round is complete, and it’s usually calculated by adding the amount of money raised in the round to the pre-money valuation.

The Deal

Jack and Jill went to Sand Hill to raise their Series A. They want to raise $7 million. They meet with many, many investors, and ultimately work out a deal with two new firms. One of their previous investors, BlackBox, opted to participate in the round. Here’s the breakdown:

• Cormorant Ventures will lead the round by investing $4 million
• Provident Capital is participating with its investment of $2 million
• BlackBox Capital rounds out the round with $1 million

Analysts at Cormorant Ventures determine that Internet of Wings Inc. is worth $15 million prior to any investment. This is its “pre-money valuation.” Although it’s tempting to think that the company’s post-money valuation would be $22 million (by summing the pre-money valuation and the amount being raised here) we’ll see that the post-money valuation is actually a bit higher due to the discount and cap provisions used by the seed investors.

The final signing of checks and legal paperwork sets off a cascade of conversions and capitalization table adjustments as the company issues new shares to its investors.

Seed Conversions

Let’s start with our Seed investors whose investments will convert to equity at this stage.

Opaque Ventures invested $2.5 million in a SAFE with the ability to purchase shares at a 20% discount to the pre-money valuation at Series A. The Series A price is $1.50 per share ($15 million pre-money valuation divided by 10 million shares, the number of shares originally created when the firm was incorporated, which we noted earlier), so at a 20% discount ($1.20 per share), Opaque Ventures’ $2.5 million investment converts to 2,083,333 shares ($2.5 million divided by $1.20 per share) valued at $3.125 million, a 1.25x multiple on invested capital.

In the Seed round, BlackBox Capital invested $2.5 million in a SAFE with a valuation cap of $10 million. This allows them to purchase shares at $1.00 per share ($10 million cap / 10 million shares outstanding), resulting in the purchase of 2.5 million shares from their seed investment. At the new $1.50 share price, BlackBox Capital’s Seed investment is now valued at $3.75 million, a 1.5x multiple on invested capital.

Series A Investors

At a Series A stock price of $1.50, Cormorant Ventures purchased 2,666,666 shares with its $4 million investment. Provident Capital purchased 1,333,333 shares with its $2 million investment. And with its $1 million follow-on funding in the Series A round, BlackBox Capital purchases an additional 666,666 shares of Series A stock.

Ownership Breakdown

Here’s how the ownership of the company breaks down after the Series A round. Let’s start first with our capitalization table after the Series A funding round is complete.

The post-money valuation of the company after raising its Series A round is roughly $28.875 million. Recall our temptation to say the post-money valuation should be $22 million ($15 million pre-money valuation plus $7 million raised in the round), but that would be incorrect in this case.

Clauses like valuation caps and discounts allow investors to purchase shares at a price lower than the prevailing price per share. This increases the number of shares they are able to purchase, and thus results in more shares being created.

To further illustrate that, let’s think about what would have happened if IoW’s Seed investors didn’t implement caps or discounts. They would have been issued stock at the regular share price of $1.50 and, accordingly, wind up with a smaller percentage of the company. The terms they put into their investment agreements both raised the post-money valuation of the company by generating more shares, and they served to give these investors a larger chunk of the company than they’d otherwise be entitled to if they purchased shares at the $1.50/share price paid by Series A investors.

Here’s the percentage breakdown of the company’s different share classes between Seed and Series A rounds.

One of the other important things to note is that, on a percentage basis, Jack, Jill, and the employee equity pool’s relative share of the company has decreased on a percentage basis. This is known as dilution. Financially, dilution isn’t really a big deal, because even a shrinking slice of the proverbial pie is still valuable if the size of the pie – the value of the company – continues to grow. For example, although holders of Common Stock own just 52 percent of the company after its Series A round, their collective stake is now valued at $15 million. And so long as share prices continue to increase in subsequent rounds, the value of their stock will continue to increase as well even as they continue to be diluted.

(Down rounds flip the math here, both diluting current shareholders, and driving down the value of their stake. More on that in a coming piece.)

Where dilution does matter, though, is in the control and voting structure of the company. In most voting agreements, voting power is often tied to the number and type of shares held by a given shareholder, founders and other investors can find themselves outnumbered during key votes as their percentage ownership of the company is diluted. This is the principal reason why many investors include anti-dilution provisions, to maintain their control in a company.

What We Learned

Raising outside money is one of the more esoteric aspects of being an entrepreneur, but it doesn’t need to be confusing. Although we used relatively simple terms here, we discussed the differences between pre- and post-money valuations, saw how different types of deal terms affect valuation and percentage ownership, and explained how raising new rounds of funding can lead to dilution of founders’ and early investors’ stakes in a company over time.

Things are often considerably messier in the real world, but the underlying mechanics discussed here still hold.

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