Anti-Dilution: Protecting Investors or Punishing Founders?

For first-time founders, navigating the intricacies of a venture capital term sheet can be daunting. Each clause carries significant implications for your company’s future and your ownership stake. One such critical clause is “Anti-Dilution Protection,” designed to safeguard investors’ interests, particularly during challenging financial periods for your startup. This article will break down Anti-Dilution Protection, explaining why it matters, its common variations, and what founders should keep in mind.

Definition

Anti-dilution protection is a crucial provision in venture capital investment agreements that shields investors from the impact of a “down-round.” A down-round occurs when a company issues new shares at a price lower than what investors paid in a previous funding round.

This provision ensures that investors maintain the economic value and ownership percentage of their original investment by adjusting their shareholdings or the conversion price of their convertible securities (like preferred shares).

So,if you bought a slice of a pizza for $10. Later, the pizza shop sells more slices of the same pizza for $5 each because business isn’t as good. Without anti-dilution, your $10 slice effectively loses value because there are now cheaper slices out there. Anti-dilution protection ensures that your original investment is “re-valued” or you get more slices (shares) so that your ownership percentage and the value of your initial investment is not unfairly reduced by the lower-priced new shares.

Why it Matters?

This clause is vital for several reasons:

Investor Protection: It safeguards investors against a decrease in the value of their equity and their proportionate ownership if the company struggles and needs to raise funds at a lower valuation.
Attracting Capital: Offering anti-dilution provisions can make your company more attractive to investors, as it provides their investments with an additional layer of insurance. It will be protected against future dilution, especially in volatile markets.
Maintaining Control: By ensuring their ownership percentage is maintained, investors can retain their intended influence and decision-making power within the company.

Common Variations

Anti-dilution provisions primarily come in two forms, each with different implications for founders:

Full Ratchet Anti-Dilution:
This is the most aggressive form of anti-dilution for investors and the most punitive for founders. If new shares are issued at a lower price in a down-round, the investor’s conversion price for their preferred shares is reset to match that new, lowest price, regardless of the number of shares issued in the down-round. This effectively means the investor receives a significant number of additional shares to maintain their original investment’s value as if they had invested at the lower, new price.
- Impact on Founders: Full ratchet can be extremely dilutive to founders and other common shareholders. It disproportionately shifts the burden of the down-round onto existing common stockholders.
- Negotiation: This method is rarely seen in modern venture capital deals due to its harsh impact. Founders are recommended to resist full ratchet provisions.
Weighted Average Anti-Dilution:
This is a more common and balanced approach. It adjusts the investor’s conversion price based on a weighted average of the original investment price and the new, lower price, taking into account the number of new shares issued in the down-round. The adjustment is less severe than full ratchet because it considers the overall capital structure.
- Broad-Based Weighted Average: This is the most founder-friendly and customary version. It calculates the weighted average by including all outstanding common shares, preferred shares (on an as-converted basis), and all outstanding options, warrants, and convertible securities. By including a broader base of shares, the dilutive impact on founders is reduced.
- Narrow-Based Weighted Average: This version is less favourable to founders as it typically only considers the outstanding preferred shares and sometimes common shares, excluding other dilutive instruments like options. This results in a greater adjustment and more dilution for founders compared to the broad-based method.
- Impact on Founders: While still resulting in some dilution, weighted average anti-dilution provisions distribute the impact more equitably, making them a more palatable option for founders. Broad-based weighted average is generally the preferred method.

Let’s understand with the help of a simplified example:

Scenario:

An investor buys 1,000,000 preferred shares at $1.00 per share.
Later, the company has a down-round and issues 500,000 new shares to another investor at $0.50 per share.

1. Full Ratchet Anti-Dilution:

The original investor’s conversion price immediately drops to $0.50 (the new lowest price).
This means their 1,000,000 preferred shares can now convert into 2,000,000 common shares (1,000,000 / 0.50).
The investor effectively doubles their common shareholding without any additional investment, severely diluting founders.

2. Broad-Based Weighted Average Anti-Dilution (Simplified Formula Example): A common formula is: New Conversion Price (CP2) = CP1 * (A + B) / (A + C) Where:

CP1 = Old Conversion Price (e.g., $1.00)
A = Number of outstanding shares deemed before the new issue (1,000,000 original shares + existing common shares + options)
B = Total consideration received by the company for the new issue divided by the old conversion price (($0.50 * 500,000) / $1.00 = 250,000 shares)
C = Number of new shares issued (500,000)

A (original outstanding shares on a fully diluted basis) was 1,000,000.

CP2 = $1.00 * (1,000,000 + 250,000) / (1,000,000 + 500,000)

CP2 = $1.00 * (1,250,000) / (1,500,000)

CP2 = $0.83

In this case, the investor’s conversion price is adjusted to $0.83, meaning their 1,000,000 preferred shares now convert into approximately 1,204,819 common shares (1,000,000 / 0.83). This is still dilutive for founders but significantly less than the full ratchet.

Evolv’s Recommendations

Avoid Full Ratchet: Whenever possible, strongly negotiate against full ratchet anti-dilution. It is highly unfavourable to founders and can severely impact your ownership and motivation, especially during a down-round when you need to be most focused on recovery.
Push for Broad-Based Weighted Average: This is generally considered the fairest and most market-standard anti-dilution provision. Understand how “fully diluted shares” are defined in the formula, as a broader definition is more beneficial to founders.
Negotiate Carve-outs and Exceptions: Ensure that certain share issuances do not trigger anti-dilution clauses. Common exclusions include:
- Shares issued for employee stock option plans (ESOPs).
- Shares issued in connection with acquisitions.
- Shares issued upon the exercise of warrants or convertible notes that were outstanding prior to the financing round. These carve-outs provide flexibility for your company’s growth and operational needs without inadvertently penalizing you or triggering anti-dilution.
Understand the Calculation: Pay close attention to the specific formula used for weighted average anti-dilution. The precise definition of what constitutes “shares outstanding” (e.g., fully diluted vs. only issued shares) can significantly affect the outcome.
Time Limitations: Some anti-dilution provisions may have a time limit or apply only to a certain number of future financing rounds. This can be a point of negotiation.
Impact on Future Fundraising: Be aware that overly aggressive anti-dilution terms can make it harder to attract new investors in subsequent rounds, as they might be deterred by the potential for extreme dilution.
Demotivation: Recognize the psychological impact of dilution during a down-round. Unfair anti-dilution terms can severely demotivate founders at a critical time for the company. Strive for terms that balance investor protection with founder incentives.

Understanding anti-dilution provisions is key to safeguarding your interests as a founder. By being informed and knowing what to negotiate, you can ensure a fairer deal that protects both your investors and the long-term success of your company.