Dilution and conversion mechanics

A market-referenced conversion price is set by formula rather than agreed in advance: a discount applied to a volume weighted average price measured over a defined window of trading days. Because the price is an output rather than an input, the number of shares issued is not known when the instrument is signed. Four terms decide how far it can travel.

Key takeaways

• The selection rule inside the window matters more than its length. The average of every day in a 20-day window, the lowest single day, and the average of the three lowest days produce very different prices from identical trading.
• A floor converts an unknown into a maximum. With a floor, the largest possible share issuance is calculable on day one; without one it is unbounded as the price falls.
• An ownership blocker limits speed, not total. A cap at just under 5% or 10% of outstanding shares controls how much stock reaches the market at once. It does not reduce the shares ultimately issuable.
• The exchange cap is a separate constraint. Nasdaq Listing Rule 5635(d) requires shareholder approval for a 20% Issuance priced below the Minimum Price, and comparable rules apply elsewhere.

What the pricing formula is made of

Every market-referenced instrument prices off three components: a reference price, a look-back window, and a discount. The reference is usually a volume weighted average price rather than a closing price, because a VWAP is harder to move with a small trade at the bell. The window is a run of consecutive trading days ending on or shortly before the conversion date.

What separates a defensible formula from a punitive one is the selection rule. "The VWAP for the trading day immediately preceding" is a point measurement. "The average VWAP over the 10 consecutive trading days preceding" smooths it. "The lowest VWAP in the 20 consecutive trading days preceding" is not an average at all: it is an option on the worst day in a month. All three get written as "VWAP" in a summary term sheet.

The four terms that decide the outcome

Worked illustrative arithmetic

Take a company with 100,000,000 shares outstanding raising US$5,000,000 through a convertible. The only variable below is how the conversion price is set. The reference price is US$0.10 in the first two cases and US$0.04 in the last two, to show what a 60% fall does to each structure.

Three things fall out of that table. The floorless case issues more new shares than were outstanding before the raise, from the same US$5,000,000. The floor does not make the financing cheap; it makes the worst case knowable. And the gap between the second and third rows is caused entirely by the share price, which is why the direction of travel of the stock is a term of the deal whether anyone writes it down or not.

Blockers, caps and the order they apply in

An ownership blocker stops a holder converting to the extent it would push its beneficial ownership above an agreed percentage, most often just under 5% or just under 10%. Beneficial ownership is a defined concept: under the United States rules a person is generally treated as owning shares it has the right to acquire within 60 days, which is what makes a blocker effective. The blocker throttles the flow of stock and keeps the holder below reporting and short-swing thresholds; it does not change the total.

The exchange cap does change the total, at least until shareholders vote. On Nasdaq, Listing Rule 5635(d) requires shareholder approval before a 20% Issuance at a price below the Minimum Price, the lower of the closing price before signing and the 5-day average closing price before signing. A well-drafted instrument stops at the cap and treats approval as a condition, rather than leaving the issuer to choose between breaching its listing rules and breaching its contract. See the Hong Kong general mandate and the SGX discount limit for the same idea in other forms. The rule is set out on this site under the Nasdaq 20% rule.

Reading a term sheet in the right order

Read the floor first, then the selection rule inside the window, then the blocker, then the exchange cap. Only then read the discount, which is the number everyone negotiates and the least important of the five. A firm floor with a modest discount is almost always less dilutive than a generous headline discount with no floor.

Then read what happens on a default or a delisting, whether the reset is one-way, and whether the holder has any obligation not to sell short. Those terms separate a financing from the failure mode described in death spiral financing. The instruments are on the instruments hub; the resale question after conversion is answered in Rule 144. Send the four terms and we will do the arithmetic.

Related reading

• All insights
• Rule 105 and the trading window before pricing
• Capital-raising routes
• Check whether you qualify

Primary sources

• Nasdaq Listing Rules — Rule 5635
• eCFR — Rule 13d-3, beneficial ownership
• eCFR — Rule 105 of Regulation M

Dilution and conversion mechanics: frequently asked questions

What does a VWAP window actually measure?

It measures the volume weighted average price of the shares over a defined number of trading days before a conversion or drawdown. What matters is not the length of the window but the selection rule inside it. An average of every day in the window behaves very differently from the lowest single day, and different again from the average of the three lowest days.

What is a conversion floor and why does it matter?

A floor is a minimum conversion price below which the formula cannot go, however far the share price falls. It is the single most important protective term in any market-referenced instrument, because without it the number of shares issuable on conversion is unbounded. With a floor, the maximum share issuance is knowable on day one, which is also what makes the instrument capable of being disclosed honestly.

What is an ownership blocker?

A contractual cap that prevents a holder converting to the extent it would take its beneficial ownership above an agreed percentage of the outstanding shares, commonly set at just under 5% or just under 10%. It limits the amount of stock that can reach the market at any one time, and it keeps the holder below reporting and short-swing thresholds. It slows conversion down; it does not reduce the total shares issuable.

Does an exchange cap the number of shares an issuer can issue?

Frequently, yes. On Nasdaq, shareholder approval is required before a 20% Issuance priced below the Minimum Price under Listing Rule 5635(d), so many convertible instruments carry an exchange cap that stops issuance at that threshold until approval is obtained. Other venues use their own capacity rules, such as a general mandate expressed as a percentage of issued shares. The cap belongs in the document, not in a footnote.

Is dilution always bad for existing shareholders?

Dilution reduces each existing holder's proportionate stake, always. Whether that is bad depends on what the capital does. Issuing 30% of the company to fund an asset that doubles enterprise value leaves every holder better off in value and worse off in percentage. The arithmetic is neutral; the use of proceeds is not.