The corporate spectacle better known as The We Company IPO officially and mercifully came to an end September 30 when The We Company (“We Co.”), the corporate parent of WeWork, requested that the Securities and Exchange Commission consent to the withdrawal of We Co.’s registration statement because it “no longer wishes to conduct a public offering of securities at this time”. The filing of the withdrawal request was no shocker, following six weeks of intense scrutiny by prospective IPO investors and the media over WeWork’s business model, $1.6 billion in losses in 2018, related party transactions, questionable corporate governance and CEO Adam Neumann’s bizarre behavior, all of which prompted the company’s board last week to fire Neumann, put ancillary businesses up for sale and slash the company’s implied IPO valuation from $47 billion down to as low as $10 billion.
Much focus has been placed on We Co.’s largest investor, SoftBank, which directly or indirectly through its Vision Fund invested more than $10 billion in the company, with its latest investment earlier this year valuing the We Co. at $47 billion. Softbank clearly was not happy about the prospect of an IPO price based on a $10 billion valuation. But a feature in We Co.’s amended and restated certificate of incorporation will help cushion the blow when the company completes its next offering: dilution protection, or anti-dilution rights.
Without any desire whatsoever to pile on and kick We Co. when it’s down, I thought this was a good occasion to delve into the concept of dilution and the mechanics of anti-dilution.
There are two types of dilution experienced by investors: percentage dilution and economic dilution. Percentage dilution is not necessarily a problem; economic dilution always is.
Percentage dilution is simply the mathematical result of one’s share in the whole declining as a result of the whole expanding. This automatically occurs when a company sells shares to new investors. For example, if a company with 1,000 outstanding shares completes the sale of 500 new shares to a new investor, the incumbent shareholders will experience percentage dilution in that their percentage of the outstanding shares drops as a result of the new issuance from 100% to 67% (1,000/1,500). Percentage dilution may be an issue if the dilution causes the holder to fall below a percentage threshold needed to maintain certain rights, such as board representation or veto rights. Otherwise, percentage dilution is not a cause for concern; it certainly was not for Softbank in WeWork.
Economic dilution, on the other hand, is always a problem for an incumbent investor. Economic dilution is experienced by an investor when the company issues new shares at a lower price per share than the price paid by that previous investor, a so-called down round. For example, a Series A investor purchases one million Series A shares at $1 per share. After failing to hit one or more milestones, the company burns through the Series A proceeds and must raise another round. But to attract investors in its Series B round after the economic hiccups, the company must agree to a lower valuation and sells shares at $0.50 per share. As a result, the value of the Series A investor’s shares has decreased from $1 million to $500,000. That’s economic dilution, and the Series A investor is not happy.
As a measure of protection against economic dilution, venture investors typically negotiate at the time of their investment for anti-dilution rights, which get baked into the company’s amended certificate of incorporation. In plain English, it means that if the company subsequently issues stock for consideration per share lower than what the investor paid, the company will be obligated to issue additional shares to the investor upon conversion of the preferred.
Preferred stock is almost always convertible into common, which is what allows the preferred to benefit from any upside on a sale of the company. In a disappointing exit with low proceeds, the preferred holder would just get his liquidation preference, expressed as an amount per share (usually equal to the amount per share paid by the investor). If the company sells for an amount that exceeds the aggregate liquidation preference, the preferred converts into common to share in the excess proceeds.
In a conversion, the number of shares of common that each share of preferred is convertible into is equal to the original price per share paid by the investor divided by the conversion price, which is initially equal to the price per share paid by the investor (resulting in a one-for-one conversion rate). The anti-dilution section triggers a downward adjustment in the conversion price resulting in additional shares issuable upon conversion. The magnitude of the adjustment depends on the extent to which the formula is investor friendly (full ratchet) or company friendly (weighted average), as explained below.
It’s important to understand that anti-dilution does not trigger issuance of additional (preferred) shares at the time of the down round, but rather additional (common) upon conversion which would occur on a sale of the company. That’s because anti-dilution is intended to protect the upside, not the downside. Otherwise, the issuance of additional preferred shares would result in unfairly increasing the liquidation preference amount, which would not be intended. If the pre-down round investor were to receive additional preferred shares for no additional consideration, the investor would receive an increase in his down side protection, an unintended windfall.
There are two general methods of calculating the anti-dilution adjustment: full ratchet and weighted average.
Full Ratchet Anti-Dilution
Full ratchet anti-dilution is the most investor friendly, and extremely rare. In plain English, it provides that the conversion price gets adjusted all the way down to the lower down round price, irrespective of the number of shares that were issued in the down round. Basically, a do-over in the earlier round that would result in the earlier round investor receiving for the same dollar amount of his investment, on conversion, a number of shares calculated based on a price per share equal to the lower down round price. As an absurd example for illustration, if a Series A investor invested $1 million and received one million shares constituting 20% of the outstanding, and the company then issued just one Series B share for one penny, the post-full ratchet cap table would indicate that the Series A holder would then have 100 million as-converted shares ($1,000,000/$0.01) constituting 96% of the fully-diluted, as-converted outstanding shares (100,000,000/104,000,001). The real victims? The founders. In my absurd example, the founders dropped from 80% post-Series A to just 3.99% post-Series B.
Weighted Average Anti-Dilution
Weighted average anti-dilution is far more common and considered more reasonable because it takes into account, in addition to price, the number of additional shares issued in the down round relative to the pre-money shares outstanding. The actual formula is as follows:
CP2 = CP1 x ((A + B) ÷ (A + C))
- “CP2” is the new (post-down round) conversion price;
- “CP1” is the conversion price in effect immediately before the down round;
- “A” is the number of shares of common stock (including all shares issuable upon exercise of outstanding options or upon conversion of convertible securities) outstanding immediately prior to the down round;
- “B” is the number of shares that would have been issued in the down round if price per share were equal to CP1 (determined by dividing the aggregate consideration received in the down round by CP1); and
- “C” is the number of shares issued in the down round.
There’s an important wrinkle to weighted average anti-dilution protection. Weighted average anti-dilution could be either broad based or narrow based, depending on the extent of options and convertible securities that are included in shares outstanding. The formula that appears above is broad based because the number of shares outstanding includes all shares issuable on exercise of options and on conversion of convertible securities. The broader the formula (i.e., the more securities that are included in the outstanding), the less of an adjustment to conversion price.
Under narrow based weighted average anti-dilution, the only securities that would be included in shares outstanding (in addition to actually outstanding common shares) would be the number of shares outstanding of the particular series of preferred whose conversion price is being adjusted.
SoftBank’s Anti-Dilution Protection in We Co.
Page F-115 of We Co.’s S-1 Registration Statement states that all preferred stock (including preferred held by SoftBank) is subject to “broad weighted-average anti-dilution protection”. For companies that have issued multiple series of preferred, each series has a separate conversion price (which typically starts out being equal to the purchase price per share). The beneficial ownership table in We Co’s S-1 indicates that SoftBank directly or indirectly is the beneficial owner of shares in 11 different series of We Co. preferred stock. SoftBank’s last investment in We Co. was $5 million at a $47 billion valuation, with a per share purchase price of $112 per share.
At this point, it remains to be seen when (if at all) We Co. will resume its efforts to go public. But what’s clear from the S-1 and many media reports, We Co. needs to raise cash. Before it withdrew its IPO, We Co. and its underwriters were rumored to be prepared to drop the valuation to as low as $10 billion. So whether the next round is a public or private offering, it almost certainly will be a down round.
Given the eleven different series invested in by SoftBank, each with its own price and conversion price, the amount of time it would take to calculate all the anti-dilution adjustments would be a multiple of what it has taken me to write this blog post. In fact, the conjecture is that the complicated calculations needed to figure out the anti-dilution adjustments to SoftBank’s various conversion prices in its multiple funding rounds weighed heavily on SoftBank’s decision to cause We Co. to pull the IPO plug for now. Ultimately, We Co. couldn’t proceed with the IPO without SoftBank’s, part of a package of vetos over major decisions usually negotiated by investors.
So how impactful will the anti-dilution adjustment be with respect to SoftBank? Even under the more relaxed weighted average method of anti-dilution protection, because of the magnitude of the drop in valuation from SoftBank’s previous investment, coupled with the enormous number of shares that would be issued in We Co.’s IPO (if it does happen) at that lower valuation, the additional number of common shares issuable to SoftBank on conversion will be dramatic. So much so that Renaissance Capital estimates the anti-dilution adjustments here could result in the largest IPO anti-dilution adjustment ever, as large as $200 million to $500 million worth of additional shares issuable on conversion to preferred stockholders, mostly going to SoftBank. Moreover, it was disclosed in the S-1 that upon payment of the final $1.5 billion installment of SoftBank’s most recent Series G-1 round investment, We Co. will issue it a warrant to purchase a large but undisclosed number of additional shares at a very low but undisclosed price per share.
In the final analysis, anti-dilution softens the economic dilution blow of the down round to the preferred stockholders, resulting in massive disproportionate percentage and economic dilution to the common stockholders.