Business Lawyer, Vol. 59, No. 1 (November 2003), pp. 23-42. "This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association."


As most venture capital investors are aware, the economic downturn of the past two years—and the concomitant decrease in private company valuations—has created an opportunity for significant returns on new venture investments seldom seen since the early 1990s. Yet while the investment opportunities of the current economic environment may have attractive financial valuations, they frequently come with the added cost of significant transactional complexity. In particular, the issuance of securities by a private company at a price that is below the price previously paid by the company's investors (typically referred to as a “down-round” financing) may trigger one or more forms of price-based antidilution protection. Price-based antidilution protection, which is found in the charter documents of most venture-backed emerging growth companies, is used by many venture capital investors to minimize the dilution that occurs when a portfolio company issues stock in a down-round financing by increasing the rate at which the existing investors' shares of preferred stock (which are typically purchased by venture capital investors) convert into shares of common stock. Upon receiving an “antidilution adjustment,” the holders of a company's shares of preferred stock will thereafter be entitled to convert their shares into a greater number of shares of common stock, thereby diminishing the dilutive effect of the down-round financing. Given the significant effect an antidilution adjustment may have on a company's capitalization following a down-round financing, understanding the application of a company's antidilution protection has become a critical component of an investor's due diligence review prior to a portfolio company investment.

Despite the increased focus within the venture capital community on antidilution protection, there remains considerable uncertainty regarding the proper application of the various types of antidilution formulas. This uncertainty is made all the more troubling for venture capitalists and entrepreneurs in light of the considerable economic ramifications of antidilution protection. Absent a thorough understanding of a company's antidilution protection, a new investor may find itself unknowingly diluted by prior investors' antidilution adjustments. Likewise, the form of a company's antidilution protection may place significant constraints on the form and valuation of a potential down-round financing. The intent of this Article is to clarify the operation of these ordinarily opaque provisions and to provide five guiding principles for venture capitalists and entrepreneurs to apply when negotiating a down-round financing.