Fundraising Terms: Anti-Diltuion Provision (Part 1)

Hello Founder,

Last time, we discussed the liquidation preference clause (parts 1 and 2), which determines how much each shareholder (common and preferred) gets in a liquidation event. 

Today’s term focuses on Anti-Dilution Provision, which protects investors during a down round.

Ideally, as a company develops, it increases its value, and thereby its share price. However, in a down round, the share price decreases to less than the price paid by the investors in the previous round. To be protected against such economic (or price-based) dilution, investors require anti-dilution protection.

The price-based anti-dilution clause provides a protection mechanism that will be triggered whenever the company issues additional equity securities (shares or instruments convertible into shares) at a price that is lower than the price paid for the shares by the investors. The anti-dilution protection is an agreed right attached to the preferred shares and serves as an advantage for the preferred shareholders (Series [X] investors) over the common shareholders (founders, employees, etc.), who will pay the price for the dilution.

A typical anti-dilution clause in a term sheet follows:

Anti-dilution Provisions: The conversion price of the Series A Preferred will be subject to a [full ratchet/broad-based/narrow-based weighted average] adjustment to reduce dilution in the event that the Company issues additional equity securities—other than shares (i) reserved as employee shares described under the Company’s option pool; (ii) shares issued for consideration other than cash pursuant to a merger, consolidation, acquisition, or similar business combination approved by the Board; (iii) shares issued pursuant to any equipment loan or leasing arrangement, real property leasing arrangement, or debt financing from a bank or similar financial institution approved by the Board; and (iv) shares with respect to which the holders of a majority of the outstanding Series [X] Preferred waive their anti-dilution rights—at a purchase price less than the applicable conversion price. In the event of an issuance of stock involving tranches or other multiple closings, the anti-dilution adjustment shall be calculated as if all stock was issued at the first closing. The conversion price will also be subject to proportional adjustment for stock splits, stock dividends, combinations, recapitalizations, and the like.

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When anti-dilution protection is triggered, the protected investors obtain the right to receive additional shares. This right may be exercised either by either of two mechanisms:

(a) adjusting the conversion ratio of the preferred shares into common shares, or

(b) by directly issuing additional shares to the investors. 

One of the advantages of the first mechanism (adjusting the conversion ratio) is that the investors do not have to pay for their additional shares. 

If the system of adjustable conversion rates is the preferred compensation mechanism, the anti-dilution provision could be drafted as follows:

In the event that the Company issues new shares, or securities convertible into or exchangeable for shares, at a purchase price lower than the applicable conversion price of the Series [X] Shares, then the conversion price of the Series [X] Shares will be subject to a [full-ratchet/weighted average] adjustment (…)

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Under the second mechanism (direct issue of shares), the investors may be obliged under the applicable law to pay a certain price for the shares – potentially a considerable amount if a large number of new shares are issued, but significantly less than the initial share price paid by the investor. This mechanism is rarely used.

If additional shares are to be issued to the investors as the preferred compensation mechanism, the anti-dilution provision could read as follows:

In the event that the Company issues new shares, or securities convertible into or exchangeable for shares, at a purchase price lower than the applicable purchase price of the Series [X] Shares, the holders of Series [X] Shares may elect that the Company shall procure (to the extent that it is lawfully able to do so) the issue to the holders of Series [X] Shares, of additional Series [X] Shares against payment of such an amount that the average purchase price they have paid is equal to the purchase price at which the new shares are issued.

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Types of Anti-Dilution Protection

There are two basic types of price-based anti-dilution protection: 

1. Full ratchet anti-dilution protection, and 
2. Weighted average anti-dilution protection 

We will now discuss the types of protection, based on the assumption that parties have agreed on the first mechanism (conversion adjustment) as the preferred compensation mechanism.

‍Full Ratchet Protection

The full ratchet anti-dilution protection is the most investor-friendly type of protection. Under the full ratchet protection, the investors will be put in the position as if they had invested at the new, lower issue price, that is, the earlier round price is effectively reduced to the price of the new issuance. This completely preserves the value of their initial investment in a down round. 

A more extensive full ratchet clause, explaining the extent of the protection, could be drafted as follows:

In the event that the Company issues equity securities at a purchase price less than the applicable conversion price of the Series A Shares, then the conversion price of the Series A Shares will be subject to a full ratchet adjustment, reducing the applicable conversion price of the Series A Shares to the price at which the new equity securities are issued.

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For example, if a company has raised a Series A round at $2 per share and raises a subsequent Series B round at $1 per share. Under the full ratchet protection, the holders of Series A shares will be put in the position as if they had purchased the Series A shares at $1 per share instead of $2 per share, thus entitling them to twice the number of shares they held before the Series B round.

The full ratchet protection focuses on the new price per share and compensates the investors for the full difference in share price, regardless of the real impact of the dilutive event. As per the example above, the compensation for the holders of Series A shares will be the same regardless of whether the company issues only 1 new Series B share or 1 million new Series B shares. This means that irrespective of the size of the Series B round – $1 million or $10 million – the Series A investor will receive two times the number of shares they had before the Series B round. 

This can cause significant dilution of the value of the shares held by the shareholders that are not protected against price-based dilution (typically the common shareholders, i.e. founders and employees). The effects of a (full ratchet) anti-dilution protection may be perceived by those shareholders as a severe injustice and may have a demoralizing effect on them. 

Companies that are in a position to negotiate better terms will try to have the investors settle for a less onerous form of anti-dilution protection, such as the weighted average anti-dilution protection, which we will discuss in the second part of this post.

We hope you found this post insightful. See you next time!