DEFINITION of Narrow-Based Weighted Average

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. A narrow-based weighted average takes into account only the total number of outstanding preferred shares for determining the new weighted average price for the old shares.

BREAKING DOWN Narrow-Based Weighted Average

The new weighted average price is adjusted for the preferred shareholder, thus providing protection against dilution. The narrow-based method is the most favorable for investors, as it lowers the price of the preferred shares more than other methods.

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, and early employees receive options, those stock equivalents will not be factored into the weighted average.

How the Narrow-Based Weighted Average Diminishes Dilution

The effect of this weighted average is comparable to the broad-based weighted average in that it reduces the conversion price. This reduction is calculated from the ratio of number of shares of common stock that would be issued through a down round at the current conversion price but then compared with the number of shares of common stock issued in the down price at the lower offering. Greater anti-dilution protections are afforded to the investor due to the later shares being more heavily weighted and issued at the lower offering price.

Narrow-based weighted average might be part of the negotiated terms for later funding rounds for a company as more shares are issued and valuations increased. Typical, this is not put into practice in early financing rounds.

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.

The effect 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 issued via the broad-based weighted average.

The difference that results from this weighted average is dependent on the relative pricing and size the dilutive financing and the total number of outstanding common and preferred shares.