Anti - Dilution Provisions: Overview, types and tips.

Anti - Dilution Provisions: Overview, types and tips.

Wondering what are anti-dilution provisions every time you want to invest? Here’s what you need to know about these types of clauses.

Starting from how many times your eyes crossed an anti-dilution clause and how many times you were confused about them, to taking a decision not to clause a deal because of unclear anti-dilution provisions, this article will help you put your feet on the ground when it comes to anti-dilution provisions.

When investing in a company, investors usually have two investment choices: a cash contribution and/or in-kind services contributions, in return of share ownership in the share capital of the company. In the post-incorporation phase of the company, and at any time afterwards, the company can increase its capital while issuing new shares, which will reduce the shareholders equity positions, this concept is called “the dilution”.

Therefore, a decrease in the company’s earnings per share (EPS) will be observed, which will not only lead to disadvantaged shareholders but will also affect the prices of its shares, which usually lowers the company’s stock prices in the market. In brief, dilution refers to a shareholder’s ownership decreasing as a result of new shares issuance. This is where anti-dilution clauses interfere. Anti-dilution provisions are also referred to as anti-dilution clauses, subscription rights, subscription privileges, or preemptive rights.

Anti-dilution provisions protect an investor’s equity stake from dilution. A company may issue new shares with a round of equity financing or let its options exercised by their owners. In either case, the total number of shares outstanding will increase, while the investor still owns the same number of shares. Therefore, the investor’s percentage ownership in the company will decrease.

Which measures can be taken in order to resist/protect shareholders from dilution?

Investors are granted protection through anti-dilution clauses only when the new shares are issued at a lower price than the one initially invested by them, not common stock. Anti-dilution provisions are some of the times described "subscription rights," "preemptive rights," or "subscription privileges”.

We discern two sorts of anti-dilution provisions: (i) the weighted-average and (ii) the ratchet based.

i.????????????????Weighted average anti-dilution protection is far more common. As the name implies, this method applies a price based on the weighted average price all investors have paid so far. For weighted average anti-dilution protection, the conversion price is not automatically lowered to the lowest share price. Instead, it’s modified based on the increase in the number of shares the company issued. Here's the formula:

New conversion price = original conversion price x (number of outstanding shares + amount received by the company/original conversion price) + (number of outstanding shares + number of new shares issued)

ii.??????????????Full-ratchet anti-dilution is the easiest to calculate and also the least common method. It uses the lowest preferred share price as the conversion price for holders of preferred shares. Full-ratchet anti-dilution protection is the strongest form of anti-dilution protection, which is one reason it’s used less (more on this later). Here, the new conversion price adjusts to the lowest conversion price implied by any financing round. The formula is: number of common shares = (number of preferred shares) x (original share price/conversion price).

Now that we know that anti-dilution provisions can be present in many forms and just like all types of provisions, an anti-dilution provision is negotiable. The more shares held by preferred shareholders, the less ownership for common stockholders such as founders and employees. In other words, the stronger the anti-dilution protection for investors, the greater the potential dilution for founders.

Here are a few important things to keep in mind when negotiating these provisions:

-???????Anti-dilution provisions are negotiable, and different parties in each financing round will have different perspectives on the right approach.

-???????Full-ratchet anti-dilution provisions are rare, partly because they can put off future investors who may not get the same rights. Also, founders are resistant to them because they could effectively whittle the founders’ ownership stakes down to nothing.

-???????Investors might accept fewer protections in order to preserve the company’s ability to raise money in the future or avoid diluting founders and employees. For instance, some founders may negotiate “pay-to-play” terms. These are terms that require investors to participate in future financing rounds to receive anti-dilution protection.

-???????Anti-dilution provisions aren’t typically found in convertible notes or SAFEs, since those convert into preferred shares following a priced financing round. Plus, the valuation cap or discount rate already serves as a form of anti-dilution protection.

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