Investors want protection over their investments. While startups are often risky, issuances that include an anti-dilution provision can tactically attract more investors. The provision protects investors from losing the valuation of their preferred stock if a startup issues more.
Typically when a startup issues more stock, the overall value decreases, hurting the initial investors.
Anti-dilution provisions protect investors from having their equity diluted or devalued. An anti-dilution is critical to venture capital’s preferred stockholders who may lose their ownership percentage with the issuance of new shares.
The provision protects investors by allowing them to convert their preferred stock to common stock with certain price protections. Additionally, when investors convert preferred to common stock, they gain voting rights.
How does dilution work?
It’s a simple concept; dilution refers to the percentage of stockholders' ownership when a company issues new stock. The new stock adds to the startup’s total capital, reducing each stakeholder's percentage.
For example, if you own 100 shares in a company with 1,000 total shares, you own 10% of the company. However, if they double their shares in the future to 2,000, your ownership drops to 5%.
The purpose of the anti-dilution provision
Anti-dilution provisions protect early investors. For example, early stockholders can convert preferred stock to common stock at a pre-determined price if a startup issues more shares.
With the guarantee that preferred stockholders could convert to common stock at a lower-than-normal price, it may be easier to secure more funds during early fundraising rounds.
Importance of the anti-dilution clause
Anti-dilution clauses may help entice more investors. Investors may be willing to invest more when you offer to protect their equity. Anti-dilution clauses may also protect the value of the common stock when done right.
Since founders can negotiate anti-dilution clauses, they may look different for every startup.
What are the types of anti-dilution protection?
There are two types of anti-dilution protection: price-based and contractual. Price-based is the most common, but contractual gives founders more options.
1. Price-based protection
There are two types of price-based protection: full-ratchet and weighted-average. A weighted-average is more common than a full-ratchet, but founders should understand both when negotiating their contracts.
A. Full-ratchet anti-dilution
A full-ratchet provision allows current investors to convert their shares to common shares at a new lower price. For example, if they purchased shares at $15 from a startup and then issued new shares at $10, existing investors could convert at a lower cost.
B. Weighted-average anti-dilution
The weighted-average anti-dilution protection works differently and is based on the following formula:
New conversion price = Old conversion price x (outstanding shares before conversion + total shares with the new issue)/(total shares before conversion + new shares issued)
The weighted-average protection allows startups to adjust the conversion ratio to decrease the amount of dilution that early investors experience.
2. Contractual protection
Contractual protection is less common in startups but allows stockholders the right to negotiate more shares during a dilution. This is done regardless of the lower price of the new issued shares and protects shareholders from losing their percentage.
How do you calculate anti-dilution?
The anti-dilution calculation depends on the method chosen—full-ratchet or weighted-average.
Calculating full-rachet anti-dilution
Calculating the full-ratchet anti-dilution protection is easy:
Total common shares = Preferred shares issued x (original share price/conversion price)
Calculating weighted-average anti-dilution
The weighted-average anti-dilution provision isn’t as simple. You won’t get the common stock share price. Instead, the increased shares modify the conversion price based on the number of new shares.
Anti-dilution provision scenario example
Joe Smith is a private investor interested in investing in tech startup XYZ. He has researched the risks of investing in startups and requests that a full-ratchet anti-dilution clause be included in the terms of his investment.
Under this clause, Joe will receive additional XYZ shares if it issues new shares at a price lower than his original investment. This would effectively give Joe a greater stake in XYZ, diluting the ownership of the founders and other investors.
In such a situation, Joe will receive additional XYZ shares that would increase his ownership to match the percentage of his original investment.
For example, if Joe originally invested $100,000 for 10% of the company and XYZ later issues new shares at $50,000, Joe would receive additional shares that would bring increase his ownership to 10%. This will ensure that the new share issuance does not dilute Joe and retains his original percentage of ownership in the company.
When are anti-dilution provisions used to protect investors?
Anti-dilution provisions occur during different financing rounds. Therefore, the negotiation can occur at multiple points throughout the process.
Why is anti-dilution important as a founder?
Founders view anti-dilution provisions as important to avoid a loss of equity during a down round. They know their investment is secure and will convert attractively should the startup need additional future funding.
Does preferred stock financing include protection of price-based anti-dilution?
Anti-dilution provisions are negotiable. They aren’t automatically included in an offering, but investors can negotiate it into the contract.
Does the issuance of low-price stock affect price-based anti-dilution protection?
Yes, low stock prices negatively affect price-based anti-dilution protection because it’s part of the formula when determining the weighted-average anti-dilution provision.
Do SAFEs and convertible notes have price-based anti-dilution protection?
SAFE and convertible notes typically don’t have an anti-dilution protection since they already have a valuation cap that serves as a form of dilution protection.
Anti-dilution provision: Key takeaways
Founders can choose from price-based protection, including full-ratchet and weighted-average. Full-ratchet is more common, allowing current investors to seamlessly convert shares at the new price, whereas weighted-average uses a complex formula to reduce the dilution investors experience. You may also consider contractual protection, allowing investors to negotiate the number of shares if dilution occurs.
Understanding the different types of anti-dilution provisions can help startup founders determine how to proceed. Anti-dilution protects investors but can have some downsides for founders, so understanding your options is key.
Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.