USA Law and Practice Contributed by: D. Scott Bennett, Nicholas A. Dorsey, Virginia M. Anderson and Ellen H. Park, Cravath, Swaine & Moore LLP
Anti-Dilution Broad-based weighted-average anti-dilution provisions are standard in the USA. These pro - visions protect preferred stockholders from a down round financing by adjusting the rate at which the preferred stock converts into common stock based on the sale price used in the down round as well as the number of shares sold in the down round. The formula used to determine the conversion rate is based on the number of shares deemed outstanding immediately prior to the down round. For “broad-based” provi - sion, the number of shares deemed outstand- ing includes shares reserved for issuance under outstanding options and warrants. Narrow-based weighted-average anti-dilution is similar, but excludes shares reserved for issu - ance under outstanding options and warrants in the number of shares deemed outstanding for purposes of the formula. By including fewer shares in the formula, there is a larger anti-dilu - tion adjustment for the preferred stockholders. In very rare, distressed situations, preferred stockholders may be able to secure “full ratchet” anti-dilution provision, which adjusts the conver - sion rate solely based on the sale price used in the down round. This results in the largest anti- dilution adjustment for preferred stockholders and is the least favourable outcome for common stockholders (who are not granted the same pro - tection). Liquidation Preference Venture capital investors hold their interests in convertible preferred stock, which receives a senior liquidation preference, prioritising pay - outs to such holders over payouts to common stockholders in the case of a sale or winding-up of the company. “non-participating liquidation preference” is most common and provides that
preferred stockholders’ board designee(s); and • a certificate of incorporation, or a charter, that: (a) defines the rights, preferences, privileges and restrictions of each class and series of stock; and (b) typically addresses dilution protections, voting rights, dividend rights, liquidation preferences and preferred stock conver - sion rights. The NVCA updates these form documents from time to time, including several notable updates in October 2023. 3.5 Investor Safeguards There are a number of safeguards built into the NVCA form documents that are utilised to pro - tect venture capital investors from a downside scenario. There are also additional levers that can be built into these safeguards to provide further downside protection. These protections are often influenced by fluctuations in the ven - ture capital market oscillating between investor- friendly conditions and company-friendly condi - tions. Pre-Emption Rights Pre-emption rights permit stockholders to par - ticipate in an upcoming financing round in order to preserve their ownership level in the compa - ny and avoid dilution caused by new securities being issued. If any stockholder with pre-emp - tion rights chooses not to purchase its full pro rata share of the new securities being issued, the remaining stockholders with pre-emption rights are granted the right to purchase such securities. In the USA, pre-emption rights are commonly only given to the major investors in the company.
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