Narrow based anti-dilution is a law designed to make sure that existing investors are not penalized when a company releases new shares of stock or obtains increased financing. When establishing a new weighted price for existing shares, this type of calculation accounts for only the total outstanding preferred shares.

What Is Anti-Dilution Protection Using Weighted Average?

This is the type of anti-dilution protection most commonly offered to stockholders. This formula provides an adjusted rate for conversion of preferred stock to common stock depending on how much money has already been raised by the company and the price per share at the time it was raised compared with how much money will be raised in the dilutive round of funding and the new price per share. 

The original purchase price will always exceed the weighted average price, which is divided into the original purchase price to figure out how many shares of common stock each preferred stock share can be converted into (always greater than one). This results in a new, lower conversion price for preferred stock shares and an increased conversion rate. 

The price of the preferred series after the conversion can be found by multiplying the conversion price as described above by the result of dividing the sum of the common outstanding pre-deal by the common issuable stock amount by the sum of the common outstanding pre-deal and the common issued in the new deal. 

This formula can be modified to determine either a narrow-based or a broad-based weighted average. 

How Does the Broad-Based Weighted Average Work?

When calculating a broad-based average, find the common outstanding by combining all outstanding shares of both preferred and common stock, as well as any common stock that could be exercised based on outstanding options, common stock reserved to be issued in the future, and warrants and other convertible securities that are outstanding. 

How Does the Narrow-Based Weighted Average Work?

Like a broad-based weighted average: 

  • The narrow-based weighted average reduces the conversion price for stock shares. 
  • It involves finding the ratio of the number of shares at the current conversion price for common stock compared with those issued at the lower offering, both at a down price. 
  • This means that later shares are issued at a lower price and more heavily weighted, protecting early investors from dilution of their shares. 
  • This strategy is rare in early financing rounds but often used to negotiate the terms of stock purchases in later rounds.

When calculating this weighted average, the term "common outstanding" refers to the amount of common stock that can be issued when a series of preferred shares is converted. Alternatively, this formula could include the amount of common stock available for issue if all preferred shares were converted to common stock (broad-based formula). The latter option provides a smaller anti-dilution adjustment, with the difference dependent on the relative pricing and size of the financing that is diluted and the number of outstanding preferred and common stock shares

Venture Capital Term Sheet Anti-Dilution Provisions

If a venture capitalist owns 20 of 100 total shares of a company, he or she has 20 percent ownership. If the company issues 100 more shares, the investor in question now owns 20 out of 200 shares, which dilutes the ownership stake to 10 percent, thus reducing the amount of control that investor has over the company. 

This is often not an issue if the newly issued stocks are priced higher than the investor originally paid, since his or her shares are now more valuable. If the new stocks are issued at a lower price, which is known as a down round, the venture capitalist's shares are worth less than he or she paid for them.

For this reason, many venture capitalist term sheets contain provisions designed to protect the investor from dilution by lowering the conversion price of preferred shares so they can be advantageously converted to a higher number of common shares. This, in turn, dilutes the shares of the common shareholders, which often includes employees and even founders of the company. That's because the amount of common shares they have decreases as these are transferred to the preferred shareholders.

If you need help with establishing anti-dilution provisions for your company, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.