Anti-dilution protection lowers the price at which an investor’s preferred stock converts into common stock if the company later sells shares at a lower price per share (a down round). The investor ends up with more common shares on conversion, and the founders and other common holders absorb the difference. Almost every venture deal uses the broad-based weighted average formula, which softens the adjustment. Full ratchet is rare and worth refusing, and a SAFE should have no anti-dilution at all.
Key takeaways
- Anti-dilution protects investors against a lower price, not against a lower percentage. Nobody gets a guaranteed ownership percentage.
- Broad-based weighted average is the market standard. Full ratchet is aggressive and should come with a very good reason.
- Standard carve-outs exclude option grants, SAFE and note conversions, stock splits and other ordinary issuances.
- The provision lives in the certificate of incorporation, and a majority of the preferred can usually waive it.
- Post-money SAFEs have no anti-dilution provision. Decline side letters that try to add one.
What is anti-dilution protection?
When a company issues new shares, every existing holder’s percentage goes down. That’s ordinary dilution, and anti-dilution provisions don’t prevent it. See Equity Dilution.
Anti-dilution protection is narrower. Preferred stock converts into common stock at a conversion price that starts out equal to the price the investor paid. If the company later sells stock at a lower price per share than that, the anti-dilution formula lowers the conversion price. Each preferred share then converts into more than one common share, so the protected investor recovers part of the value lost to the lower price.
A down round is a round priced at a lower price per share than the prior round. The amount raised doesn’t matter. See What Is a Down Round?
What’s the difference between full ratchet and weighted average?
Full ratchet resets the protected series’ conversion price to the new, lower price, no matter how few shares are sold at that price. If an investor paid $1.00 per share and the company later sells even a handful of shares at $0.50, the investor’s preferred converts as if they had paid $0.50. Their 2,000,000 shares of preferred convert into 4,000,000 shares of common. That extra common comes almost entirely out of the founders and employees, which is why full ratchet is so investor-friendly and so rare.
Weighted average adjusts the conversion price based on both the new price and how many shares are sold at it. A small down round produces a small adjustment. A large down round produces a bigger one, but never as big as full ratchet.
Weighted average comes in two versions. Broad-based counts all outstanding common, preferred on an as-converted basis, and options and warrants in the starting share count. Narrow-based counts fewer shares, which makes each adjustment larger. Broad-based is the standard in both Series Seed and NVCA documents. See Series Seed vs NVCA Documents.
How does the broad-based weighted average formula work?
The formula is:
CP2 = CP1 x (A + B) / (A + C)
CP1 is the conversion price before the down round, and CP2 is the new conversion price. A is the number of shares outstanding before the down round, counted on a fully diluted basis. B is the number of shares the new money would have bought at the old price (the new money divided by CP1). C is the number of shares actually issued in the down round.
Put simply, A is the company’s size before the round, B is the shares that “should” have been issued, and C is the shares that actually were.
Example. A company sold Series A preferred at $1.00 per share and has 10,000,000 shares on a fully diluted basis. It then raises $1,000,000 by selling 2,000,000 shares at $0.50.
- A = 10,000,000
- B = $1,000,000 / $1.00 = 1,000,000
- C = 2,000,000
CP2 = $1.00 x 11,000,000 / 12,000,000 = about $0.917.
A Series A investor holding 2,000,000 preferred shares would now convert into about 2,181,818 common shares instead of 2,000,000. Under full ratchet, the same investor would convert into 4,000,000. That gap is why the choice of formula matters so much more than whether the term exists.
What issuances are carved out?
Anti-dilution only applies to new issuances below the conversion price that aren’t excluded. The standard carve-outs exclude:
- Options and restricted stock granted to employees, directors, advisors and consultants under the board-approved equity plan
- Shares issued when preferred stock, SAFEs, convertible notes or warrants convert or are exercised
- Stock splits, stock dividends and similar recapitalizations, which are handled by a separate proportional adjustment
- Shares issued in board-approved acquisitions, strategic partnerships, equipment leases or bank financings
Read the definition of excluded securities closely. It’s where most of the founder-friendly drafting lives.
Can anti-dilution be waived?
Yes. Anti-dilution sits in the certificate of incorporation, not in a side agreement, so changing it requires a charter amendment approved by the required preferred vote. Most charters also let the holders of a majority of the preferred (or of the protected series) waive an adjustment for a particular financing.
In practice, that waiver is how most down rounds get done. The new investor usually doesn’t want the earlier investors’ conversion prices to reset, and the earlier investors often agree to waive in exchange for the company getting funded. Sometimes the waiver is tied to a pay-to-play requirement: investors who don’t buy their share of the new round lose their anti-dilution protection or convert to common.
Do SAFEs have anti-dilution protection?
No. A post-money SAFE fixes the investor’s ownership at the valuation cap, and if the priced round comes in below the cap, the SAFE converts at the lower round price. That is the SAFE holder’s protection. Once the SAFE converts, the holder gets the same preferred stock, with the same anti-dilution terms, as the new investors.
Some investors now ask for a side letter that adds weighted average anti-dilution to a SAFE. That isn’t standard, and we recommend declining it. It layers a price adjustment on top of a fixed ownership percentage and makes conversion harder to model. See SAFE.
What if an investor wants a guaranteed ownership percentage?
Say no. Anti-dilution protects against price, not percentage. A promise that an investor will keep, say, 10% of the company no matter what (sometimes called a dilution lock or full anti-dilution on percentage) pushes all future dilution onto everyone else. Later investors see it in diligence and will usually require it to be removed before they invest.
What should founders negotiate?
Accept broad-based weighted average. It’s market, and fighting it costs credibility you need for other terms. Refuse full ratchet unless the company truly has no other option. Make sure the carve-outs cover your equity plan, SAFE and note conversions and ordinary strategic issuances, and that the waiver can be given by a majority of the preferred rather than by each series or each investor.
Go deeper: For a full walkthrough, see our Founder’s Guide to Seed Funding and Founder’s Guide to Series A.
For the other economic terms in a priced round, see Liquidation Preference and Protective Provisions. If you’d like help negotiating a term sheet, see our Series Seed and Series A services or contact us.
