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A down-round is a situation in which a business lowers its valuation by raising money through the issuance of shares at a price lower than it did in its prior funding round. This situation can dilute the ownership and economic value of existing investors’ shareholdings.
An anti-dilution provision is essential to safeguard against such dilution. Keep reading to understand more about how anti-dilution provisions work and the types available to protect investors.
Anti-dilution provision– What is it?
In the event of a downturn, an anti-dilution clause in the investment agreements is intended to shield current investors’ stock stakes from being diluted. This clause is triggered when new shares are issued at a lower price than what was paid by the existing investors, ensuring that their ownership percentage remains relatively stable despite the issuance of cheaper shares.
How does anti-dilution provision shareholder agreement work?
The mechanism involves adjusting the equity held by existing investors to counteract the dilution effect. It is often achieved through the adjustment of conversion rates for convertible securities such as preferred shares.
In essence, the provision keeps existing investors’ proportionate ownership in the business intact by allowing them to convert their preferred shares into a larger number of common shares in the event that new shares are offered at a cheaper price.
Consider an investor holding 15% of a company with 10,000 shares, meaning they own 1,500 shares. A drop in valuation prompts the business to issue 5,000 additional shares at a discounted price.
- Without anti-dilution, the investor’s ownership would decrease to 10% (1,500 out of 15,000 total shares).
- With anti-dilution, the provision adjusts the investor’s share conversion rate, enabling them to maintain closer to their original 15% ownership despite the issuance of new shares.
Anti-dilution provision classification
The anti-dilution mechanism adjusts the conversion price of convertible securities in two principal ways:
Full-ratchet:
In the event of a downturn, this clause modifies the conversion price of preferred shares to reflect the cost of the newly issued shares. It essentially recalculates the initial investment as if it had been made at a lower price.
Suppose an investor originally bought shares at ₹200 per share. Under a full-ratchet provision, the investor’s share price would be adjusted to ₹100 if the firm thereafter issued new shares at ₹100 per share. Thus, their investment now accounts for twice as many shares as originally, maintaining their ownership stake.
Weighted average:
This clause establishes a weighted average of the new share price and the previously issued share price as the basis for determining the new conversion price. It takes into account the quantity of newly issued shares as well as the price.
Within the weighted average anti-dilution provisions, there exists a further classification:
Broad-based weighted average:
This mechanism is the more commonly adopted form of weighted average protection due to its balanced approach.
CP2=CP1×(A+C)(A+B)
Where:
- CP2: Adjusted conversion price
- CP1: Existing conversion price
- A: The total number of shares outstanding on a fully diluted basis before the new issue.
- B: The number of shares that could be bought with the new round’s investment at the old conversion price.
- C: The actual number of new shares being issued.
Narrow-based weighted average
The narrow-based weighted average protection is similar to its broad-based counterpart but with a narrower focus. When calculating the total number of existing shares (A in the formula), it excludes certain types of shares such as unissued stock options, warrants, and other convertible securities.
This approach can offer slightly more protection to existing investors than the broad-based method because it considers fewer shares in the calculation, thus resulting in a slightly higher adjusted conversion price.
For example, let’s consider ZZZ Pvt. Ltd. to illustrate
Initial capital:
| Shareholder | Shares (Fully diluted) | Shareholding |
| Founder 1 | 24,000 | 24% |
| Founder 2 | 24,000 | 24% |
| Investor | 42,000 | 42% |
| ESOP | 10,000 | 10% |
| Total | 1,00,000 | 100% |
Assumptions for down-round financing:
- CP1: ₹100
- B: 12,000 calculated as(24,000x₹50)/₹100
- C: 24,000
Adjusted conversion price:
| Protection type | Adjusted conversion price |
| Broad-Based | ₹90.32 100x(1,00,000+12,000)/(1,00,000+24,000) |
| Narrow-Based | ₹89.47 100x(90,000+12,000)/(90,000+24,000) |
Assuming the broad-based approach, the adjusted conversion price might be calculated as ₹90.32, considering all dilutive securities in the calculation.
Using the narrow-based approach, if we exclude certain dilutive securities from our calculation, resulting in an effective outstanding share count of 90,000 instead of 1,00,000.
Difference between full-ratchet and weighted average anti-dilution provision
| Feature | Full-ratchet | Weighted average |
| Conversion price adjustment | Adjusts to the new share price directly | Adjusts based on a weighted average formula |
| Impact on investors | Provides maximum protection to investors, preserving their ownership share | Offers balanced protection, mitigating dilution but not eliminating it |
| Impact on company and founders | Can lead to significant dilution of founders and other stakeholders | Less severe dilution for existing shareholders, more company-friendly |
| Flexibility | Less flexible, as it strictly ties conversion rates to the lowest share price | More flexible, accommodating a range of scenarios with its formulaic approach |
Bottomline
In navigating down-rounds, the anti-dilution provision for founders and investors plays a key role, striking a balance between investor protection and maintaining equity, with a weighted average method offering a fair, flexible solution.
FAQs
Anti-dilution provisions in a term sheet protect investors from diluting their equity stake if the company issues new shares at a lower price than previously. These clauses adjust the conversion rate of preferred shares to common shares, ensuring investors maintain their proportional ownership. There are mainly two types: full-ratchet, which adjusts to the new share price directly, and weighted average, which calculates a new conversion price based on a formula considering the new and existing share prices and quantities.
Anti-dilution provisions for founders are mechanisms within a company’s financial and legal agreements designed to protect the founders’ ownership percentages from being diluted significantly in future funding rounds. These provisions are especially relevant during down-rounds, when new shares are issued at a lower price than previous rounds. While more commonly associated with protecting investors, these provisions can also be tailored to ensure that founders retain a certain level of control and ownership, thereby safeguarding their interests amidst new capital influxes.
The standard anti-dilution provision typically adopted in investment agreements is the weighted average method. This method adjusts the conversion price of preferred shares when new shares are issued at a lower price based on a formula that accounts for the number of new and existing shares and their prices. It strikes a balance between protecting investors from dilution and not overly penalising the company or its founders.
Anti-dilution in a shareholder agreement is a protective clause for investors designed to prevent the dilution of their ownership percentage when new shares are issued at a lower price than they originally paid. It typically adjusts the terms of convertible securities, such as preferred shares, to ensure investors can maintain their proportional stake in the company.
An example of anti-dilution is when a company initially issues shares to an investor at ₹100 per share. Later, if the company issues new shares at ₹50 per share during a down-round, an anti-dilution provision like the weighted average method might adjust the investor’s original conversion rate. This adjustment ensures the lower-priced issuance doesn’t significantly dilute the investor’s shareholding. Say, instead of 1,000 shares, the investor might now be entitled to 1,500 shares, maintaining their proportionate ownership in the company.