What is an Anti-Dilution Provision?

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  • 04 Dec 2023
What is an Anti-Dilution Provision?

Key Highlights

  • Anti-dilution provisions provide for the right of investors to maintain their ownership percentages in the event of the issue of new shares.
  • The dilution refers to a decrease in the holder's shareholding due to the issuance of new shares.
  • The anti-dilution provisions are divided into full ratchet and weighted average.

Anti-dilution provision measures are introduced to protect investors' and stakeholders' interests, most of which have been associated with the company from an early stage. Provisions ensure that when a company issues new shares on the market, investors retain their right to maintain an original shareholding of more than 50%. Rights to protect the interests of preferred shareholders are most closely related to anti-dilution provisions.

The issue of new shares by the company may reduce the value of the ownership percentage of existing investors and stakeholders. When more shares are in flow than when the stock option holders or stakeholders holding other optionable securities exercise their options, investors and early-stakeholders risk losing out on the value of their current claim to ownership of the company. There is, therefore, a need for dilution protection, which is geared towards the interests of early investors.

In particular, for preferred shareholders in venture capital deals whose shareholdings can be reduced if subsequent issues of the same stock are listed at lower prices, dilution is a complicated problem to solve. Anti-dilution provisions could prevent this by modifying the conversion rates between convertible securities, such as company bonds or preferred shares and common stock. An anti-dilution clause can preserve the investor's original shareholding percentage.

Full ratchet and weighted average are the two types of anti dilution provisions.

1. Full Ratchet

A complete ratchet provision would protect investors in options and convertible securities. This provision enables investors to convert at the lowest sales price offered. As a result, they are protected if the new offer price is lower than the conversion price of an investor's shares.

2. Weighted Average

A formula is applied to calculate the new conversion price in the weighted average method. The new conversion price will be O x (A + B) / (A+C). Where:

  • O: The old conversion price.
  • A: Shares that are still outstanding before the new issue.
  • B: Consideration of the new issue has been received.
  • C: New shares have been issued.

The owners of preferred shares will continue to benefit from the full ratchet method since it allows them to convert at a lower price than is available. A weighted average process will protect some of the value of their preference shares. Conversely, the conversion price will always be higher than a complete ratcheting mechanism.

Most companies that issue convertible securities use anti dilution provisions. The provisions are significant in the venture capital area because a number of funding rounds have already taken place. As they allow convertible securities to remain at a higher cost, they are also used to encourage companies to maintain their financial targets.

It's important to note that the anti-dilution provision does not apply to everyone. The parties would not negotiate for the inclusion of an anti-dilution clause in some situations. This means that the guarantee provided by anti-dilution clauses can come at the cost of additional investors. This is a significant issue given that the vulnerable shareholder also serves as the founder or key employee of the company.

This is why they may lose motivation to contribute to the company's success when their shares are diluted too much. Investors with knowledge won't wish to reduce the entrepreneurs' drive to grow their businesses. However, when several investors are involved and multiple funding rounds are launched, anti-dilution clauses can significantly impact a company's business process.

Conclusion

The antidilution provisions provide a buffer for investors to protect their shareholdings against the dilution or loss of value. This can be the case where, due to an increase in the total number of shares outstanding, the percentage of the owner's shareholding in a company decreases.

FAQs on Anti-Dilution Provision

Anti-dilution clauses are essential as they help to protect the value of an investor's shareholding in a company. Dilution occurs when a company issues additional shares through an equity fund raising round or other means, such as employee stock options.

The number of common shares to be converted into preferred shares in the event of a down round or other dilution will be adjusted in the term sheet by the anti dilution provisions. The purpose of such provisions is to safeguard a shareholders' shareholding percentage in the company.

Full ratchet anti-dilution protection provides the original investors' rights to that number of shares as long as they have paid a lower price than the current issue in this round.

A down round reduces the company's valuation during subsequent financing rounds. To prevent investors from suffering significant losses in the value of their investment, down rounds trigger anti-dilution provisions.

The dilution of shares is a decrease in the value of each share issued due to the introduction of new shares. Stock dilution can occur if the company raises capital by offering new shares. This can happen when a company needs additional funding for growth, paying off debt or simply running its business.

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