23 February 2023
A Critical Element in Term Sheets and Stock Agreements Anti-Dilution is a clause commonly seen in term sheets and provisions in shareholding agreements that protects investors from a decrease in the value of their invested capital. As a startup founder, understanding anti-dilution and its impact is crucial to the success of your business, particularly if you intend to raise capital through crowdfunding or convertible securities.
Anti-dilution is a provision that serves to protect investors' invested equity from losing its value in the event of a "down round." A down round occurs when a company issues shares at a lower valuation than the previous round, causing existing shares' value to reduce. In this event, anti-dilution protection ensures that the investor's equity percentage is maintained by adjusting the issue price and issuing additional shares.
There are two main types of anti-dilution protection commonly used:
In a full-ratchet mechanism, the conversion price of existing convertible securities is reset to the price per security issued in the down round, retaining the investor's percentage ownership in the company's capital base, regardless of the size of the down round. Full-ratchet changes have a significant impact on a founder's equity and capacity to attract future cash, making them uncommon in most venture capital and private equity transactions.
2. Weighted Average Anti-Dilution Protection
A weighted average method modifies the conversion ratio to compensate for the dilution caused by a down round's implied value of shares. This adjustment uses a mathematical formula that computes the number of shares that would have been issued to new investors if they paid the same price as earlier investors, compared to the number of shares issued to new investors at the lower price.
For startup founders, anti-dilution protection is crucial in such cases as crowdfunding and convertible securities. Issuing convertible securities to investors can convert into equity over time or through a specific event, such as future funding rounds. Anti-dilution protection can help protect investors by adjusting the conversion price in the event of a down round, something that can significantly impact future fundraising prospects for startups.
In crowdfunding, anti-dilution protection for early investors ensures that their equity percentages are maintained in the event of a down round, a consideration that's essential in making crowdfunding appealing to investors.
As a founder, taking the time to understand anti-dilution and its mechanisms is critical to gaining the trust of investors and ensuring the long-term success of your business. Whether in a term sheet, stock agreement, convertible securities or crowdfunding, anti-dilution protection can go a long way to preserving investors' equity percentages in your venture.
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