Anti-dilution clauses allow investors to retain their ownership percentages even if new shares are issued.
Dilution is the reduction in shareholder ownership due to new shares being issued.
There are two types of anti-dilution provisions. They are full ratchet or weighted averages.
What is dilution?
Dilution is when shareholders lose ownership of a company due to the issuance or reduction of shares. As the total capital increases, the ownership percentage decreases. It’s simple.
When you issue new stock to a company, it is called dilution. An investor might own 30 shares of 100 shares of a company; technically, he is 30 percent.
Imagine that the corporation has now issued 100 shares to raise capital. Because there are now 200 shares, the 30 percent shareholder owns only 15 percent. This is called dilution. Dilution doesn’t matter if the new shares are purchased at a fair price, and the company’s value rises. The value of the 30 shares owned by the investor also increases but the percentage owned has decreased.
The initial investor loses a portion of his control over the company if new stock is issued at a lower price and his stock value drops. Anti-dilution provisions are included in financial agreements often to protect investors’ equity.
Anti-dilution: What is it?
Venture financings offer investors some form of anti-dilution protection.
Price-based anti-dilution protection protects investors from the loss of their shares if they trade at a price different from what previous investors paid. This financial process protects the shares and assets of the initial and previous investors.
Two essential elements in recognizing preferred stock sold to investors from common stocks are anti-dilution protection and liquidation inclination. This allows founders and employees to protect their investments and save money.
The holder can easily convert common stock from preferred stock, usually on a share-for-share basis. Most commonly, the stock is changed over in the event of a qualified stock sale.
Anti-dilution based on price includes increasing the number of common stock shares into which each share of preferred stock can be convertible.
A modification to prevent dilution will also affect the voting rights of stockholders. This is because the preferred stockholder is often eligible for a vote on a common stock premise that has been changed.
Investors (or officials) ask for absolute anti-dilution protection against any dilution resulting from the resulting stock offer. This guarantees a rate responsibility for the organization until a predetermined date and time or until the occasion of a particular occasion.
These provisions can, however, limit the organization’s ability to raise funding.
Basic anti-dilution is the other type of protection preferred stock investors continuously acquire. This protection is the change in the cost of their preferred stock to common stock in the event of stock profits, subdivisions, blends, stock profits, or other appropriations, rearrangements, or similar occasions that could affect the common stock.
This means that you can have your stock in hand, convert it to another and retain the same value as in the original terms. This anti-dilution protection will allow you to keep your financial standing with the company.
An anti-dilution clause is a section of a security or merger understanding that grants the investor the right to continue his or her rate obligation for the organization through the purchase of fair shares in any future security issues.
Anti-dilution provisions can also be called “subscription rights,” “preemptive rights,” or “subscription privileges.” Preferred stock is especially subject to anti-dilution provisions.
There are two types of anti-dilution provisions:
The “weighted average” and “ratchet-based.” Existing shareholders have the right to buy offers at a lower price under the ratchet provision.
Shareholders have the right to purchase offers at a price equal to the adjusted cost of the new and old offering costs through the weighted-average provision.
Investors are protected from the risk of new shares being delivered at a higher price than they already paid by anti-dilution provisions. They also encourage organizations to achieve high performance by issuing stock at higher values when necessary.
What is anti-dilution, and why is it important?
Investors have a safety net provided by anti-dilution provisions. These provisions are part of standard stock agreements. Common stockholders have voting rights but not preferred stockholders. Common stock is converted from preferred stock to give stockholders voting rights.
Prefer stock agreements allow for the conversion of shares into common stock at a fixed price. This price would be $1.00. The ten preferred shares would convert to 10 ordinary shares at the same price. Anti-dilution provisions can adjust this price if the stock suddenly loses value because shares are issued at a lower cost.
Preferred stockholders can convert common stock at a lower price than usual. They will have more common Stock than the initial preferred stock.
What is anti-dilution protection?
By using anti-dilution protection, investors can protect themselves against dilution in a down round.
Anti-dilution occurs when the round’s conversion price is lower than the previous round. This is almost always the same as the PPS paid for the preferred stock in that round. Anti-dilution provisions increase the number of common shares that each preferred stock converts to during a capital raise.
This is crucial because investors have two options: either convert their preferred stock to common stock, share proportionally in the proceeds, or keep their preferred stock and receive their liquidation preference before the commoners receive any proceeds. Investors will always choose to receive the more significant amount.
Anti-dilution protection allows investors to keep their stake and capture more exit proceeds.
What is the working principle of anti-dilution protection mechanisms?
There are two types of anti-dilution coverage: full-ratchet and weighted average.
Full-ratchet Anti-Dilution is the most common and easiest to calculate. This method uses the preferred share price at the lowest conversion price for preferred stockholders.
The most common type of protection is the weighted average anti-dilution. As the name suggests, this method applies a price based on the weighted average price all investors have paid so far.
Essential considerations when negotiating anti-dilution protection
Common stockholders, such as founders or employees, will have less ownership if preferred shareholders hold more shares. This means that dilution could affect founders if there is more robust anti-dilution protection.
This is why founders are often against anti-dilution clauses and favor a broad-based weighted median. The negotiating leverage of each party will determine which provision makes it onto the term sheet.
These are some essential points to remember when you negotiate these provisions.
Anti-dilution provisions can be negotiable. Different parties to each financing round will have different views on the best approach.
Because they could put off future investors, full-ratchet antidilution provisions are scarce. Founders also resist them because they could reduce founders’ ownership stakes to zero.
Sometimes, future investors will negotiate with prior investors to remove anti-dilution protections. Investor disputes can lead to conflicts that could delay or completely derail a company’s ability to raise future rounds.
Investors may accept fewer protections to ensure that the company can raise more money or to avoid diluting founders or employees. You can modify anti-dilution provisions. Some founders might negotiate “pay to play” terms. These terms require investors to participate in future financing rounds to get anti-dilution protection.
Convertible notes and SAFEs don’t usually contain anti-dilution provisions. These are converted into preferred shares after a priced financing round. The valuation cap, or discount rate, already provides anti-dilution protection.
In preferred stock financings, broad-based weighted and average protections are standard. Founders should expect to be asked for them by many investors. These provisions are not likely to cause harm to founders if the company can avoid down rounds or other issuances of lower-priced shares in nonexempt transactions. Founders may be more affected by other forms of anti-dilution protection, which are less frequent. Before you accept them, it is essential to consider these carefully.
A term sheet is a document commonly used in venture capital and private equity investing to outline the terms of an investment agreement between a company, investor, or syndicate of investors. It typically includes various financial and legal considerations that govern the relationship between the parties and serves as a blueprint for the more detailed investment documents that eventually need to be drafted.
Management fees in venture capital are fees charged to the limited partners by the venture capital firm to cover its operating expenses. These fees are typically calculated as a percentage of the total committed capital to the venture fund.