In investment agreements, a "dilution provision" safeguards investors from losing their stake in a company when the firm offers shares at a reduced price in future funding cycles. This provision guarantees that investors maintain their ownership share and the worth of their shares thereby averting dilution. Should a company secure funds at a valuation lower than that of the previous rounds, existing shareholders may face a reduction in both their ownership interest and share value.
Anti-dilution provisions automatically modify conversion prices or ratios for shareholders, counterbalancing the effects of the reduced valuation. This method protects investors from a decline in their ownership portion. Anti-dilution clauses provide a safety net for investors when a company issues new shares at a lower valuation. They help investors retain their proportional ownership in the company.
The key difference between full ratchet and weighted-average lies in how each calculates the adjusted conversion into share price, for investors.
With a full ratchet provision, the conversion price of common shares outstanding in stock is reduced to the price of the new shares issued by the company. It is typically viewed as more investor-friendly.
This protects the investor from dilution but can significantly penalize the other company's ability by drastically reducing the original conversion price amount.
A weighted average provision considers both the old conversion price and the new share price when determining the adjusted conversion price of outstanding common stock. The investor's shares don't convert at the lowest price but rather a blended, narrow based weighted average based on relative share amounts. There are two sub-types under weighted average:
The weighted average method provides a balanced outcome for both companies and investors. While the investor is still protected from unfair dilution, the penalty to prior investors in the company valuation is not as harsh as full ratchet.
The full ratchet formula changes the preferred stock and shares conversion price to match the price at which new shares are issued in a round.
This safeguard benefits investors by enabling them to convert their outstanding preferred shares back into common shares. However, it can significantly move voting power and dilute the ownership of founders and employees.
The weighted average formula calculates a new conversion price based on the valuation cap of the current round and the previous round. The formula is:
The weighted average method is generally seen as more favorable to founders than a full ratchet.
An anti-dilution provision is an important tool for investors, especially those investing in a startup's equity financing at early stages. Here are some of the reasons why these provisions are so critical:
Overall, anti-dilution provisions provide investors with key protections and confidence needed to invest in high-risk startups. For founders, agreeing to such clauses shows commitment to treating early investors fairly.
As a startup founder raising venture capital, you will likely encounter requests for anti-dilution provisions. Here are some key considerations when faced with negotiating anti-dilution clauses:
In summary, while anti-dilution provisions favor early investors, as a founder, you still have the power to negotiate. You can secure clauses that protect investors while maintaining flexibility with the right counsel and strategic concessions. Finding the middle ground that makes all parties feel fairly treated is key.
Investors closely consider anti-dilution protections, especially in down rounds when a company receives funding at a lower valuation than the previous round. During these instances, anti-dilution provisions are activated to counteract potential dilution, by adjusting the conversion price for investors.
Let's say you're an investor who bought preferred shares in a promising startup at a $10 million valuation and $1 per share. Unfortunately, the startup faced challenges and had to raise funds in a down round at a $5 million valuation.
Due to the down round, your ownership percentage would be diluted because new shares are issued at the down round at a lower price. However, your agreement's anti-dilution clause, specifically a full ratchet provision, would protect your investment. This provision adjusts your conversion price based on the new valuation of the down round.
With a broad-based weighted average provision, the conversion price becomes the weighted average of the new number of shares being issued and total outstanding shares. This provides partial protection against dilution. Down rounds almost always trigger anti-dilution provisions if they are in place.
Investors specifically negotiate these clauses to avoid excessive dilution of their stake when companies stagnate or decline in value. Entrepreneurs should be prepared to expect these clauses in down rounds.
Differences in the anti dilution protection in clauses exist between the United States and the European Union. In the US, these clauses are frequently seen in venture capital and growth equity funding, where institutional investors often seek protection against dilution. The full ratchet approach is prevalent among US investors.
In contrast, anti-dilution provisions are less common in the EU startup ecosystem. European investors are often willing to invest without such protections. The broad-based weighted average approach is more common when used in the EU. US startups raising a Series A round usually grant full ratchet anti-dilution protection, while comparable EU startups may not include any.
Furthermore, US courts are generally more inclined to enforce broad anti-dilution provisions than EU courts. Some EU courts have deemed certain anti-dilution provisions unfair and unenforceable.
In general, the significance of dilution protection is more pronounced in the US than in the EU. Investors in Europe tend to exhibit adaptability by incorporating dilution protection measures solely within particular high-risk contexts. Startups must recognize these variations across the Atlantic, especially when engaging in fundraising activities and navigating term sheet discussions.
While anti-dilution provisions offer important protections for investors, other mechanisms can also help retain ownership percentages.
An alternative to anti-dilution is preemptive rights, where current common stock or preferred stock shareholders can buy a share of any new company stocks issued to retain their ownership stake.
Preemptive rights allow shareholders to preserve ownership percentages without complex anti-dilution formulas and adjustments. However, shareholders generally must purchase these new shares, whereas anti-dilution clauses adjust preferred share conversion prices automatically.
Overall, preemptive rights provide an alternative mechanism to minimize dilution but do not offer the same downside protection as anti-dilution clauses. The choice depends on negotiations between founders and investors.
Investors use dilution provisions to safeguard their ownership stake from unfair dilution when companies issue new shares. Here are a couple of points to note when :
