Anti-Dilution Protection
What is anti-dilution protection?
Anti-dilution protection is a contractual provision included as part of a stock purchase agreement, that protects early shareholders in a company from future dilution from down rounds.
What is equity dilution?
Equity dilution occurs when a company creates and sells new shares of stock to investors or creates an option pool, and the number of shares outstanding increases—diluting the ownership percentage of existing shareholders. Typically the relative percentage of dilution that occurs over time decreases as the company’s valuation increases, but that is not always the case.
What are the triggers of anti-dilution protection?
Anti-dilution protection is typically triggered by the price per share of a round being less than the price per share from a prior round.
Do all issuances of lower priced stock trigger anti-dilution protection?
Typically yes, but there are a few exceptions. For example the issuance of stock options to employees, and the issuance of warrants in connection with lines of credit.
Why do investors sometimes require anti-dilution protection?
Investors typically require anti-dilution protection because they want to maintain their ownership stake and minimize the downside risk associated with their investment. Early-stage investors are most likely to require anti-dilution protection, as the risk (and subsequent need for protection) decreases in future rounds.
Why do startups agree to anti-dilution protection?
Startups typically agree to anti-dilution protection because they need to raise capital and it’s included as a stipulation of the funding terms they receive from early investors. That said, it’s important to note that agreeing to anti-dilution protection may have a negative impact on the company's ability to raise money in the future.
What are the types of anti-dilution protection?
There are two types of anti-dilution protection: full-ratchet and weighted-average.
“Full-ratchet” offers the highest level of anti-dilution protection for investors. In the event of a down round, it adjusts the investor's existing price per share downward to match the price of the new shares being issued.
“Weighted-average” is the most common form of anti-dilution protection for investors. In the event of a down round, it adjusts the investor's existing price per share downward based on the weighted average of all the prices that previous investors have paid. The new shares are also given a weighting based on the total number of outstanding shares.
Note: both full-ratchet and weighted-average protection have no effect if the price of the new shares is higher than the price of the shares the existing investors previously purchased.
What are the types of weighted-average anti-dilution protection?
There are two forms of weighted-average anti-dilution protection, broad-based and narrow-based. The difference lies in the definition and ultimate calculation of the number of “outstanding shares”.
In the broad-based approach, the number of outstanding shares includes all types of issued shares including preferred shares, options, warrants and employee option pools. In the narrow-based approach, only the outstanding preferred shares are considered.
The broad-based approach results in preferred shareholders getting fewer common shares when converted, which makes it more beneficial for founders.
How to calculate the effects of full-ratchet anti-dilution protection?
To calculate the effects of full-ratchet anti-dilution protection on the underlying ownership that an investor has, you need to determine their conversion rate (from preferred to common shares), the original price they paid per share, their original ownership stake and the new share price. To determine the new shares the investor owns, take the original shares they owned, multiplied by the result of the original share price divided by the current share price.
For example, let’s say the conversion rate is 1:1, the original price they paid is $10, they own 1M shares and the new share price is $5.
New shares owned = 1M * (10 / 5) = 2M
While the number of shares has doubled, the value of the shares remains the same:
- Value of old shares = $10 * 1M = $10M
- Value of new shares = $5 * 2M = $10M
How to calculate weighted-average anti-dilution protection?
The weighted-average calculation is similar to the full-ratchet except that the conversion price is not lowered to the lowest share price, but rather it is adjusted based on the increase in the number of outstanding shares. To calculate the conversion price, leverage the following formula: P2 = P1 x (A + (B / P1)) / (A + C)
Where:
- A = number of outstanding shares (prior to new sale of stock)
- B = total compensation received (through the sale of new stock)
- C = number of new shares issued
- P1 = old conversion price
- P2 = new conversion price
For example, let’s say the broad-based approach applies. The company has 1M shares outstanding and sells 500k new shares at $5, the original price of the 1M shares was $10, and the conversion rate is 1:1.
The conversion price would be: $10 * (1M + ($2.5M/$10) / (1M + 500K) ) = $8.33
The number of converted shares owned: 1.20M shares
What are the typical terms of anti-dilution protection?
When a company offers anti-dilution protection to its shareholders, it typically puts in place a number of terms and conditions to limit the potential dilution. Typically founders push back against full-ratchet anti-dilution protection and advocate for a broad-based weighted average approach instead.
Some of the most common terms are:
- The type of anti-dilution protection (full ratchet or weighted average)
- The conversion rate of preferred shares to common shares
- The specific trigger events for the anti-dilution protection
Can you negotiate the terms of anti-dilution protection?
Absolutely! The terms surrounding anti-dilution protection clauses are usually negotiable and should be negotiated if possible. One of the more interesting founder-friendly clauses that has popped up in recent years, is a stipulation that requires investors to participate in future financing rounds to receive anti-dilution protection. In this instance, if they decline to participate in a round their anti-dilution protection becomes null and void.