(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

A reader asks:  I am following-up on your post last week, Demystifying the language of VC term sheets.  My co-founder and I also have a term sheet question.  We don’t understand what a price-based antidilution adjustment is and what it’s meant to address.  The exact language under that section in our term sheet reads as follows: “Subject to standard and customary exceptions, the conversion ratio for Preferred Stock shall be adjusted on a broad weighted average basis in the event of an issuance below the Preferred Stock price, as adjusted.”  Could you please explain? Thanks!

Answer: A price-based antidilution adjustment is a mechanism to protect investors in the event that the company sells securities at a price lower than the price of the securities purchased by such investors. It can, however, be devastating to the founders.

It’s important to first understand that upon the issuance of preferred stock to an investor in a Series A round, that investor has the right (and the obligation, in certain instances) to convert the preferred stock into common stock, and conversion ratio is set at one-for-one.   The formula for determining the conversion ratio is the original issuance price of the preferred stock divided by the conversion price (which originally is the price paid).

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For example, assume that XYZ Inc. raises \$2 million in a Series A round at an \$8 million pre-money valuation, and the VC receives 2 million shares of preferred stock at \$1 per share; the conversion ratio is 1 (1 divided by 1).  Now let’s assume a Series B round 18 months later in which XYZ raises another \$2 million from a new VC, but at a pre-money valuation of \$5 million.  Each share of Series B Preferred Stock is thus priced at \$.50, and 4 million new shares must be issued to the Series B VC to raise the same \$2 million.

XYZ thus issued twice as many shares in the down round to generate the same amount of cash.  As a result, the Series A VC’s ownership is diluted (so are the founders!), and this is what a price-based antidilution adjustment is designed to address.  The position of the Series A VC is that it valued the company too high and therefore should be able to “recover” its overpayment by adjusting the conversion ratio.

There are two basic types of price-based antidilutions adjustments: “full ratchet” (or “rachet”) and “weighted average.”

Full Ratchet.  A full ratchet antidilution adjustment is draconian to the founders (and other holders of the Company’s common stock) and thus is rare.  This type of adjustment “ratchets” down the conversion price to the lowest price at which stock is issued after the issuance of the investor’s preferred stock – regardless of the number of shares presented.  In the example above, the conversion price would be \$.50, the conversion ratio would be 2 (1 divided by .50), and the Series A investor would receive twice as many common shares upon conversion.

Weighted-Average.  By use of complicated formulas, a weighted-average antidilution adjustment takes into account both the lower price and the actual number of shares issued in the down round. It is therefore more moderate and more accurately reflects the dilutive effect.  Accordingly, the greater the number of shares that are issued at a lower price the more significant the adjustment to the conversion ratio.

There are two categories of weighted-average formulas: broad-based and narrow-based.

In a broad-based weighted-average formula, the dilutive issuance is weighted against the fully diluted capital stock of the company (i.e., it assumes conversion of all preferred stock, warrants, stock options and other convertible securities).

In a narrow-based weighted-average formula, the dilutive issuance is only weighted against the outstanding securities and does not include convertible securities. A broad-based formula thus compares a dilutive issuance to a larger pie making the issuance appear less significant and therefore more appealing to the founders.

Based on the foregoing, the language in your term sheet (i.e., “adjusted on a broad weighted basis”) is the best you’re going to get with respect to this issue.

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.