Anti-dilution: What It Is and How It Works

The Purpose of Anti-Dilution Protection for Investors

Anti-dilution protection helps protect the value of investors’ shares by granting a larger percentage of a company’s pre-financing equity ownership in the event of a down round. A “down round” occurs when a company raises less money at a lower valuation than the previous round. Down rounds should be avoided if possible, as they are generally seen as a signal that the company is not doing well.

When a company issues new shares during a fundraising round, existing shareholders’ ownership stake is generally diluted. In a down round, earlier investors experience more dilution because new investors pay less per share. To prevent this, founders and investors use anti-dilution provisions.

How Anti-Dilution Protection Can Impact Ownership Percentages

Anti-dilution protection can have a significant impact on the ownership percentages of existing shareholders in a company. When new shares are issued at a lower price than the previous round, the anti-dilution protection requires the company to issue additional shares to earlier investors to compensate for the difference in valuation.

For example, let’s say an early-stage investor purchased 10% ownership in a company for $1 million. If the company later raises funds at a valuation that is 50% lower than the initial round, this would mean that their investment is now worth only $500,000. Without anti-dilution protection, the investor’s ownership percentage would be diluted by 50%, reducing their stake to just 5%.

However, if the investor has anti-dilution protection, they may receive additional shares to compensate for this loss. Depending on the terms of their agreement, they may receive enough additional shares to maintain their original ownership percentage or even increase it.

Anti-dilution protection can work differently, depending on whether it is “full ratchet” or “weighted average.”

The Different Types of Anti-Dilution Protection

There are two main types of anti-dilution protection: full ratchet and weighted average.

Full Ratchet: This type of anti-dilution protection is the most aggressive, resulting in significant dilution for founders and other shareholders. Full ratchet provisions adjust the conversion price of all outstanding securities to reflect any future issuances of new stock at a lower price, regardless of the number or price of new shares issued.

Full ratchet is essentially a “do over” for the investors. It retroactively prices the original shares, which may have been purchased years earlier, at the new share price in the down round. For example, if the investor bought 100,000 shares at $2 per share in an earlier round and the down round price is $1 per share, then the investors’ initial 100,000 shares would be converted into 200,000 shares at $1 per share. Full ratchet is heavily dilutive for founders and employees, so it’s seen as incredibly investor-friendly.

Weighted Average: Weighted average is a more reasonable approach to anti-dilution. Weighted average also adjusts the amount of investors’ shares. But rather than a pure share price adjustment, weighted average accounts for the amount of shares sold in the down round relative to the total outstanding shares. If the down round is a small offering, then the impact will be less negative for the founders and employees than if the company had a larger offering.

Weighted average seeks to strike a balance between protecting early investors from significant losses while also limiting their potential for excessive gains at the expense of later investors.

There are two ways to calculate weighted-average: broad-based or narrow-based. The broad-based calculation includes the total shares outstanding, as well as all options, warrants and shares issuable under convertible securities. On the other hand, narrow-based doesn’t include those interests in the calculation.

Without getting into the mathematical formulas, the upshot is that broad-based, weighted-average, anti-dilution is better for founders/employees than narrow-based, as it will generally produce less severe conversion price adjustments.

What Is the Formula for Anti-Dilution with Broad-based Weighted Average?

The broad-based weighted average formula for anti-dilution protection is as follows:

CP2 = CP1* (A + B) ÷ (A + C).

  • “CP2” means the conversion price in effect immediately after such issue of the additional shares;
  • “CP1” means the conversion price in effect immediately prior to such issue of the additional shares;
  • “A” means the number of shares of common stock outstanding immediately prior to such issue of additional shares (treating for this purpose as all outstanding shares of capital stock issuable upon exercise of options, or warrants outstanding immediately prior to such issue, or upon conversion or exchange of preferred stock and any other securities convertible into capital stock);
  • “B” means the number of shares of common stock that would have been issued if such additional shares had been issued at a price per share equal to CP1 (determined by dividing the aggregate consideration received by the company in respect of such issuance by CP1); and
  • “C” means the number of such additional shares issued in such a transaction.

More colloquially, think of “A” as the size of the company’s capitalization before the new round, “B” as the number of shares that “should have been issued” and “C” as the number of shares actually issued.

How Anti-Dilution Protection Is Typically Negotiated Between Investors and Founders

Negotiating anti-dilution protection can be a complex process that requires careful consideration by both investors and founders. In most cases, the terms of anti-dilution protection are included in the investment agreement between parties.

Founders should be aware that investors may request anti-dilution protection as a condition of their investment. If this is the case, it’s important for founders to understand the potential impact of such provisions on their ownership percentages and the overall value of their company.

Several factors should be considered when negotiating anti-dilution protection. These may include:

  • The type of anti-dilution protection being requested (full ratchet or weighted average)
  • The extent of the protection being requested (e.g., whether it applies to all future rounds or only certain rounds)
  • The potential impact on other shareholders and stakeholders

The best-case scenario for founders is to remove anti-dilution from the deal altogether. However, this is highly unlikely. Instead, founders should focus on ensuring that the anti-dilution provisions are broad-based weighted-average. Fortunately, this has become the most standard version of the term. If investors are pushing for full ratchet, they would need to have a compelling justification for such an aggressive ask.

The Role of Anti-Dilution Protection in Venture Capital Deals

Anti-dilution protection is a crucial aspect of venture capital deals, particularly when it comes to safeguarding investor interests. It works by ensuring that investors receive a fair return on their investments, even in the event of significant changes in the company’s valuation.

This protection is particularly important in the case of early-stage companies, which often have a high level of uncertainty and risk associated with them. By negotiating appropriate protections, investors can help to mitigate these risks and support the growth and success of promising startups.

Overall, anti-dilution protection is a critical component of many venture capital deals. By working together with investors to negotiate appropriate protections, founders can help to ensure that they are fairly compensated for the risks they take on, while also supporting the growth and success of founders and early-stage employees.


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