Anti-Dilution Provisions Sample Clauses

What is Dilution?

The term "dilution" refers to an event in which a company's shareholders' ownership is reduced as a result of the issuance of new shares in that company. The concept is simple: as the total capital increases, the ownership percentage decreases.

For example, you would have a 25% stake if you owned 25 shares in a company with 100 outstanding shares. Your ownership would be cut in half if the company issued 100 more shares in the second round of financing. As the total number of shares issued increases, the earnings per share (EPS) will decrease. Companies may try to mitigate the negative effects by repurchasing their shares.

Understanding What is Anti-Dilution Provision?

Anti-dilution provisions serve as a buffer to protect investors who don't want their equity ownership positions diluted or become less valuable. This happens when the percentage of an owner's stake in a company declines as the total number of shares outstanding starts rising

To put it another way, as the number of stockholders grows, each person's slice of the pie shrinks. An anti-dilution clause is a tool used to reduce the impact of potential stock issuance on some stockholders. It's a type of right that is commonly associated with preferred shares. Preferred stock can be exchanged into common stock at any time at the holder's discretion, generally on a share-for-share basis, and is usually converted automatically when an eligible initial public offering occurs.

Most companies use anti-dilution provisions when issuing convertible stock. Because of the numerous rounds of financing used in venture capital investing, the provisions are particularly prominent. For a more comprehensive understanding of how rounds of financing work, watch this video. They are also used to incentivize businesses to stick to their financial goals by allowing convertible securities to trade at higher prices.

Types of Anti-Dilution Provisions

There are mainly two types of anti-dilution protections: Price-based anti-dilution and Contractual anti-dilution.

Price-based anti-dilution

When a company raises funds in a down round, the issuance is viewed as diluting the value of the stock held by previous investors. As a result, to mitigate the diluting impact of potential down rounds, investors also add anti-dilution protection as part of their investment.

Contractual anti-dilution

Some stockholders can negotiate the right to receive as many additional shares of stock as they need for no additional payment to protect their percentage interest in the company from dilution from the new share issuance, regardless of the price of new shares.

Working of Price-based anti-dilution protection

To enact Price-based anti-dilution protection, the company's charter provides a provision to automatically change the rate at which preferred stock converts to common stock if the company has a down round. In the beginning, preferred stock is converted into common stock in a ratio of 1:1.

The conversion ratio of preferred to common becomes greater than 1:1 when a price-based anti-dilution adjustment is made, resulting in a transition to the common stock equivalent number in the company's capitalization table. Price-based anti-dilution are further classified into two types: Weighted Average and Full Ratchet.

Weighted Average

Weighted Average is more complicated, involving a statistical calculation that considers the amount of money the company has already earned and the price per share at which it was raised, as well as the amount being raised in diluting rounds and their price per share.

The formula below uses these numbers to measure a weighted average conversion price, which is then divided by the original purchase price to determine how many shares of common stock each share of preferred stock can be converted into. After that, you'll have a new preferred stock conversion price.

Formula: New Conversion Price = Old Conversion Price x [(A + B) / (A + C)]
A = Number of outstanding shares before a new issue
B = Total consideration received by the company for the new issue
C = number of shares issued in a down round

Full Ratchet

The Second of the most common type of anti-dilution protection is known as an absolute ratchet. The change is simple: the current preferred shares' exchange price is reduced to match the price of the new round of shares.

For example, consider the case of an investor who holds preferred shares in Company ABC with a conversion price of $10 and a complete ratchet anti-dilution clause. Company ABC, on the other hand, issues more shares at a $5 exchange price. The initial $10 conversion fee will be reduced to $5. The investor will be able to buy twice as many shares for the same price.

Comparing both the methods

Now, let us compare the two methods. In contrast, owners of preferred shares will still benefit more from the full ratchet process, as it gives them the right to convert at the lowest available price. The weighted average approach would help preserve a portion of their preferred stock's value. The conversion price, on the other hand, would still be lower than with a complete ratchet clause.

It's worth noting that, despite its obvious benefits to investors, the full ratchet formula may also be troublesome for them. To begin with, the entire ratchet would have to be revealed to new investors in the new round, potentially making the company less appealing as an investment.

Additionally, as the percentage ownership of common stock decreases, the incentive of common stockholders, including the startup's management and staff, decreases. Furthermore, any subsequent investors would almost certainly require similar cover, so the provision from later, higher-priced rounds could harm earlier preferred investors.

Importance of Anti-Dilution Protection

Investors find anti-dilution protection appealing because it provides them with a safety net. It can protect common share value if applied properly. Convertible-to-common-stock deals contain these clauses. While preferred stockholders are exempted from voting rights, common stockholders are not. When preferred stock converts to common stock, the stockholder becomes a shareholder with voting rights in the company.

There is a fixed price where a preferred stock share can be exchanged into common stock in preferred stock agreements. If this price is set at $1.00, the 10 preferred stock shares will be converted into 10 common stock shares at that price. If the stock unexpectedly loses value due to shares being issued at a lower price, anti-dilution clauses change the price.

Preferred stockholders may convert their shares to common stock at a lower price than normal, which would result in them having more common stock than preferred stock. Along with protecting investor's equity, Anti-dilution protection will encourage them to invest more.

Anti-dilution clauses protect investors if potential lending rounds are conducted at low valuations. While these safeguards are beneficial to investors, one should be aware of the possibility that anti-dilution clauses will dilute their interest. If carefully considered, anti-dilution protection in a term sheet will help investors construct a contract that will protect their interests.