How to benefit from dilution?
Another way to deal with dilution is to negotiate anti-dilution clauses in your term sheet. Anti-dilution clauses are the provisions that protect you from the loss of value in your shares due to future funding rounds at lower valuations. There are two main types of anti-dilution clauses: full ratchet and weighted average. Full ratchet is the most favorable for investors, as it adjusts the conversion price of your preferred shares to the lowest price paid by any new investor. Weighted average is more common and fairer, as it adjusts the conversion price based on the average price paid by all investors. The formula for weighted average anti-dilution is:
New conversion price = (Old conversion price * (Old shares + New shares)) / (Old shares + (New price / Old price) * New shares)
For example, if you invested $2 million in a company at a $10 million pre-money valuation, and received 2 million preferred shares with a conversion price of $1, and the company later raised $3 million at a $6 million pre-money valuation, issuing 3 million new shares at $1 each, your new conversion price with weighted average anti-dilution is:
New conversion price = ($1 * (10 million + 3 million)) / (10 million + ($1 / $1) * 3 million)
New conversion price = $0.76
This means that your preferred shares can now be converted into common shares at a lower price, giving you more shares and reducing your dilution.
Dilution is an inevitable part of venture capital investing, but it does not have to be a negative one. By understanding how to calculate, predict, avoid, and benefit from dilution, you can make smarter decisions and optimize your returns.