As venture capitalists have increased their focus on risk management, they have created innovative mechanisms to protect their interests in portfolio companies. Traditional safeguards have included board representation, protective covenants and price-based anti-dilution protection, but many VCs are now adding the use of milestones to their risk management repertoire.
Milestones are a trigger for adjustments in the rate at which the VC investor’s preferred stock is convertible into common stock, based on things such as the success or failure of a particular piece of litigation or a clinical trial. Accordingly, such conversion rate adjustments can be used to: (i) Facilitate the closing of a financing in advance of a milestone and (ii) Motivate the company’s management to achieve the milestones in order to avoid further dilution of its ownership of the company.
Traditional VC preferred stock is convertible into common stock at a rate equal to the purchase price of the preferred stock divided by a conversion price, with the conversion price initially being equal to the purchase price. Accordingly, one share of preferred stock is initially convertible into one share of common stock.
The conversion price is then adjusted following the initial preferred stock issuance upon the occurrence of certain corporate events as described below. A decrease in the conversion price will result in the preferred stock being convertible into a greater number of shares of common stock, thereby decreasing the effective company valuation at which the investor purchased its shares of preferred stock and increasing such investor’s percentage ownership of the company on an as converted to common stock basis.
Conversely, an increase in the conversion price will result in the preferred stock being convertible into a fewer number of shares of common stock, thereby increasing the effective company valuation at which the investor purchased its shares of preferred stock and decreasing each such investor’s percentage ownership of the company on an as converted to common stock basis.
Virtually all VC preferred stock terms contain structural anti-dilution protection. That is, if the portfolio company implements a stock split, stock combination or other recapitalization of the common stock after initially issuing its preferred stock, the conversion price is automatically proportionately adjusted so that the holders of the preferred stock will own the same percentage of the company on an as-converted to common stock basis as they did prior to the recapitalization.
For example, if the company implements a stock split in which each share of common stock is split into two shares of common stock, then the conversion price would be decreased to one half of the purchase price of the preferred stock with the result being that each share of preferred stock would thereafter be convertible into two shares of common stock.
Most VC preferred stock terms also contain price-based anti-dilution protection. The conversion rates of shares of preferred stock with price-based anti-dilution provisions are automatically increased when a portfolio company issues shares of its stock (or is deemed to have issued shares of stock through an adjustment to the conversion rates of other company securities) at a discount to the then effective conversion price of such preferred stock.
In these “down round” financings, the conversion price of each preferred stock share is automatically reduced to increase the rate at which each share of preferred stock converts into common stock, thereby decreasing the dilutive effect of the down round financing on the company’s pre-financing preferred stockholders. “Full ratchet” anti-dilution provisions decrease the then-effective conversion price to an amount equal to the price paid for the shares of stock issued in such down round financing irrespective of the number of shares of stock so issued. Alternatively, “weighted average” anti-dilution provisions decrease the then effective conversion price to an amount between the conversion price in effect immediately prior to the down round financing and the price paid for the shares of stock issued in such down round financing.
The extent of the reduction in the conversion price caused by a weighted average anti-dilution provision is dependent upon the number of shares of company stock deemed outstanding pursuant to the terms of such provision, the number of shares issued in the down round financing and the price at which those shares were issued.
Milestone-based conversion rate adjustments increase or decrease the rate at which preferred stock converts into common stock based upon the achievement, or failure to achieve, a certain company milestone. Such milestone-based adjustments provide a mechanism to adjust the pre-investment valuation of the company in light of the company’s performance following the investment in the company.
Accordingly, milestone-based conversion rate adjustments are often used to reduce uncertainty associated with a particular valuation and facilitate the closing of a financing in advance of a milestone. In addition, such adjustments can be used to motivate management to achieve certain company milestones in order to avoid the dilution associated with the conversion rate adjustment.
There is considerable flexibility in structuring milestone-based conversion rate adjustments. The adjustment can be structured to increase the number of shares common stock into which the preferred stock is convertible, thereby decreasing the company’s pre-investment valuation if the milestone is not achieved. This is often the case when a company wants to complete a financing prior to meeting an imminent milestone that would increase its valuation. Rather than delaying the investment, the investors will agree to invest at a higher valuation prior to the achievement of the milestone as long as they are guaranteed a conversion rate adjustment and a lower effective valuation if the milestone is not achieved.
Alternatively, the milestone-based adjustment could be structured so as to decrease the number of shares into which the preferred stock is convertible, thereby increasing the effective pre-investment valuation of the company if the milestone is achieved. In such an instance, the company will permit investment at a lower valuation prior to the achievement of the milestone so long as there is a conversion rate adjustment in place that will increase the effective valuation if the milestone is achieved.
The extent of any adjustment to the conversion rate is generally tied to the amount of the increase or decrease in valuation of the company if the milestone is or is not achieved. In addition the extent of the adjustment can vary on a sliding scale based upon the outcome of the company’s efforts to meet the milestone. For example, if the milestone is the settlement of a litigation claim, the conversion rate adjustment can be structured so as to effectively decrease the pre-investment valuation of the company on a dollar for dollar basis for the amount of money that the company spends in litigating and resolving such claim.
Use Near-Term Milestones
Of course, in neither of the above scenarios will the investor receive a step up in the value of its preferred stock if the milestone is met; however, nor will such investor be burdened with a decrease in the value of its preferred stock if the milestone is not achieved. The use of milestone-based conversion rate adjustments is therefore most appropriate when the milestone is a near term milestone. By limiting the types of milestones to those that should be achieved in the several months following the initial investment, investors can ensure that an increase in the value of the company over the long term is not entirely offset by adjustments to the conversion rate of the investor’s preferred stock.
Use Definitive Milestones
Care should be taken to choose milestones that are well defined. The determination of whether the milestone has been achieved should require as little subjective judgment as possible. In any event, investors will often insist that they be the ultimate arbiters responsible for making the determination of whether the milestone has been achieved. The company will often propose that an independent committee of the company’s board of directors be responsible for making such determination.
Conversion price adjustment formulas are typically set forth in the company’s charter and therefore are publicly available through the Secretary of State’s office. Accordingly, care should be taken, particularly with litigation or settlement based milestones, to avoid public disclosure of any milestones that may compromise a company’s negotiating position. After due consideration of applicable discovery rules, confidentiality can often be maintained through use of a cross-reference in the conversion price adjustment provision of the charter to confidential documents or through other mechanisms.
Consider Option Pool Adjustment
An increase in the conversion rate of a series of preferred stock can dramatically dilute the option pool and any other shares of common stock held by management. Accordingly, prior to its investment in the company, the investor should ensure that any stock option pool reserved for management is sufficiently large assuming that all milestones are not achieved and all conversion rate adjustments are made to the fullest extent of their terms. Otherwise, if as a practical necessity the option pool must be increased after a milestone is not achieved, then the investors may be subjected to unanticipated dilution.
Consider Price-Based Anti-Dilution Adjustments to Other Preferred Stock
An adjustment to the conversion rate of one series of preferred stock that results in the preferred stock being convertible into additional shares of common stock will often trigger price based anti-dilution adjustments to other series of preferred stock if such additional shares of common stock are deemed to be issued at a price below the conversion price of such other series of preferred stock. Accordingly, in order to eliminate such adjustments to other series of preferred stock, all milestone-based conversion rate adjustments should be explicitly excluded from the types of issuances that trigger the price-based anti-dilution adjustments.
Be Aware of Insider-Led Down Round Issues
If the initial conversion price or the adjusted conversion price translates into a down round and insiders are prominently involved in the financing, then the board of directors must carefully consider its fiduciary duties. In these circumstances, a rights offering, approval of an independent committee of the board of directors, approval of disinterested stockholders, a record of how the deal came together, releases and indemnities, among other issues, should all be evaluated and implemented to the extent appropriate when the deal is initially approved.
Milestone-based conversion price adjustments can be a useful mechanism to manage risk and facilitate the closing of a financing in advance of achievement of a company milestone and can often be used to motivate management to achieve such milestone. Care should be taken when structuring such adjustments, however, to ensure that the terms of the potential adjustments are clear and the adjustments will not produce any unintended consequences when they are triggered.
James T. Barrett is a partner at Palmer & Dodge and co-chairs the firm’s VC and Private Equity Group. Stephen M. Muniz is an associate in the firm’s Business Law Department and represents VC firms and both private and public companies in the life science and high technology industries.