Understanding Anti-Dilution

What is Anti-Dilution?

Anti-Dilution is one clause which can be seen in every investor agreement, yet many fail to understand and treat it as boilerplate. An investor's choice to invest in a target company is based on the predicted potential of its revenue, business growth, profit and loss bottomline, and also its ability to raise future capital at a higher valuation, and the price for any round reflects the aggregate of these expectations and assumptions. As the tale goes, if a company fails to fulfill its potential, causing its valuation to fall, it may have to issue its shares at a lower valuation (often referred to as “down round”) in the future, lowering the value of the investor's investment. Anti-dilution protection is a common part of most venture capital and early-stage investments, and it seeks to mitigate the impact of a future down round on existing investors. In other words, anti-dilution protects an investor's investment from a drop in the valuation as a result of future shares being issued at a lower valuation than the valuation at which the investor invested. The "earlier" investor is protected by a modification to the issue price and the issuance of additional shares. The overarching goal is to maintain current investors' rights notwithstanding a decreasing trend in the investee entity's valuation.

Types of anti-dilution

1. Price Based

A price-based anti dilution adjustment is a way to safeguard investors if the company issued securities at a lower price than the amount paid by such investors. The company’s charter documents contain a mechanism to automatically change the rate at which preferred stock converts to common shares if the company has a down round, to apply price-based anti-dilution.

Broadly, there are two widely-accepted anti-dilution protection mechanisms:

• Full Ratchet Anti-Dilution Protection;
• Weighted Average Anti-Dilution Protection.

a. Full Ratcheted 

Investors benefit the most from a full-ratchet mechanism because it resets the conversion price of existing convertible securities to the price per security issued in the down round and maintains the investor's percentage ownership in the company's capital base, regardless of the size of the down round. The provision enables investors to convert at the lowest available sale price. As a result, if the new offering price is lower than the conversion price on the investor's shares, they are protected. Naturally, this has the greatest impact on a founder's equity and capacity to attract future cash. As a result, full-ratchet changes are uncommon in well-advised VC/PE transactions.

b. Weighted Average

This type of protection modifies the conversion ratio by a certain amount to compensate for the down round's dilution of the implied value of the shares. This adjustment is made using a mathematical formula that compares (a) the number of shares that would have been issued to new investors if they had paid the same price as the earlier investors to (b) the number of shares that were actually granted to new investors at the lower price.

A weighted average technique can be broad (usually computed on a fully diluted basis where all stocks are considered outstanding) or narrow (depending on the number of outstanding securities before the down round) (only a certain subset of securities are considered outstanding, while securities like options and warrants may be ignored). In transaction papers, broad-based weighted average modifications are increasingly typical.

Example

Broad based weighted average

Formula

CP2 = CP1 * (A+B) / (A+C), where:

CP2- conversion price in effect immediately after new round

CP1- conversion price in effect immediately prior to new round

A- number of shares of outstanding share capital immediately prior to the issuance

B- number of shares which existing investor would have received if it invested at CP2

C- number of shares issuable upon conversion

c. Pay to Play

Variations include 'Pay to Play' clauses, in which a current investor receives anti-dilution protection only if that person also joins in a down round. Anti-dilution clauses with a pay-to-play condition are common in deals involving growth-stage enterprises, where investors are compelled to participate in proportion to their ownership in future fundraising rounds in order to be entitled to certain rights, including anti-dilution protection. This requirement is intended to encourage existing investors to engage in future down-rounds rather than merely reaping the anti-dilution benefits without making any more investments.

2. Contractual Based

A contractual anti-dilution adjustment is an agreement between the company and early stage investors (generally, where detailed terms are not included in the charter documents) in which the company undertakes to issue extra shares of common stock to the investors in order to maintain their shareholding percentage in the company

It is carried out independently of the price at which new issuance of shares takes place. It may be relevant to note that if the contractual anti-dilution protection adjustment is not terminated when the company seeks the following round of funding, new investors may demand that the company terminates the contractual protection rights before such round.

Conclusion

Draftsmen are unlikely to want to comprehend the mathematics underlying an anti-dilution calculation or how equations alter with changing advertising for a commonly utilised clause. In early- or intermediate-stage companies, higher information barriers are a problem. Anti-dilution rights are mostly determined by this factor. An investor is more likely to overvalue his investment if he is unfamiliar with the market, resulting in a lack of protections in the event of a down round. Identifying possible blind spots in an early-stage investment will likely result in a more nuanced anti-dilution protection that may be easier to enforce in the future.

Disclaimer:
The content of this article is for information purpose only and does not constitute advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point of time and prepared with due accuracy & reliability. Readers are requested to check and refer to relevant provisions of statute, latest judicial pronouncements, circulars, clarifications etc before acting on the basis of the above write up. The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that the Author / Treelife Consulting is not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof.