Narrow-Based Weighted Average

What Is a Narrow-Based Weighted Average?

A narrow-based weighted average is an anti-dilution provision used to ensure that investors are not penalized when companies are undergoing additional financing or issuing new shares. It takes into account only the total number of outstanding preferred shares for determining the new weighted average price for the old shares.

Understanding a Narrow-Based Weighted Average

Dilution occurs when a company issues new stock to raise capital. When the number of shares outstanding increases, each existing stockholder ends up owning a smaller, or diluted, percentage of the company, making each share less valuable.

Anti-dilution provisions such as a narrow-based weighted average help to prevent this from happening. If a company sells more shares at a lower price, the dilution protection provision will make a downward adjustment in the conversion price of the convertible securities. Consequently, upon conversion, existing investors would receive more shares of the company, thereby allowing them to maintain their original stake in the company as a percentage of the company's shares.

The narrow-based weighted average might be an aspect of the negotiated terms for later funding rounds for a venture capital company as more shares are issued and valuations increase. The intent is to safeguard the ownership stake that was granted to early shareholders as more funding rounds stand to further dilute shares and potentially weaken their ownership in the company. 

Narrow-Based Weighted Average vs. Broad-Based Weighted Average

There are two types of weighted average anti-dilution protections: broad-based and narrow-based. Where they differ is in the types of shares they take into account. Broad-based, as its name implies, is more inclusive than the narrow-based version.

A broad-based weighted average accounts for all equity previously issued and currently undergoing issuing. A narrow-based weighted average, on the other hand, only accounts for all convertible preferred shares or common outstanding preferred shares that are convertible for a specific series.

Options, warrants, and shares that are issuable as part of stock incentive pools are typically excluded from the narrow-based weighted average. For instance, if the company has an employee stock ownership plan (ESOP), and early employees received options, those stock equivalents will not be factored into the weighted average.

The impact of including the additional shares in the broad-based formula reduces the magnitude of the anti-dilution adjustment given to holders of preferred stock as compared to the narrow-based formula. Through the narrow-based weighted average formula, the number of additional shares issued to holders of preferred stock upon conversion is greater than what is issued to holders of preferred stock using the broad-based weighted average formula.

Calculating the Narrow-Based Weighted Average

The formula for the narrow-based weighted average can be expressed as follows: Issued price per share for the round x [(Common outstanding pre-deal + Common issuable for amount raised at prior conversion price) ÷ (Common outstanding pre-deal + Common issued in the deal)]

In such an instance, the common outstanding only refers to the preferred shares from the series being adjusted.

Advantages and Disadvantages of the Narrow-Based Weighted Average

The narrow-based weighted average is understandably popular with early investors holding convertible preferred shares. At times, certain prospective backers might even demand that such provisions are included before investing because they are aware that several dilutive funding rounds are likely to be forthcoming in the future.

However, companies aren't always willing to offer risk protection on shares. In many cases, they might decline to grant dilution protection rights to avoid hampering investor interest in later funding rounds and to increase the odds of fostering a company's long-term success.