Anti-dilution clauses typically arise in the context of raising capital or where more shares are issued. Dilution is simply a reduction in a shareholding that can either be a dilution of value (economic dilution) or relative ownership (percentage dilution). Anti-dilution provisions give an investor the right to maintain its proportional ownership of a company by allowing it to buy a proportionate number of shares of any future issue of shares of the company at specified or adjustedprices.
Percentage dilution occurs if an existing shareholder does not purchase that number of newly issued shares necessary to maintain its current proportional ownership (e.g. if a shareholder currently owns 10% of a company’s shares it must purchase 10% of newly issued shares to maintain its relativeownership).
Economic dilution reduces the value of an existing shareholder’s investment and occurs if shares are issued at a price that reduces the average value per share. Economic anti-dilution provisions protect investors from ‘down rounds,’ the risk of new shares issued by the company at a lower price than at the time the investor made its investment. If future capital raises occur at higher valuations then anti-dilution provisions are unlikely betriggered.
If, for example, an investor buys preferred shares in a company for $20 each, convertible on a one-for-one basis into common stock and the company later conducts another round of capital raising that values the common shares at $15 each (a down round), the investor’s shares would be devalued (economic dilution). The investor could not convert its preferred shares into common shares without losing $5 per share. An economic anti-dilution provision would protect that investor by specifying that if the company issues shares at a price lower than in the prior round in which that preferred shareholder invested, then it can obtain more shares of common stock when it converts in order to make itwhole.
A number of kinds of anti-dilution provisions are normally found in SHAs, including preemptive rights, ratchet and weighted-averageprovisions.
Pre-emptive rights, the most basic and common form of percentage dilution protection, give shareholders the right, but not the obligation, to buy new shares issued by a company in the future on a pro-rata basis in order to maintain their proportional ownership of shares. This right can apply to all classes of shares or only certain classes ofshares.
Full ratchet anti-dilution, a form of economic dilution protection gives an investor the right to buy shares at the new lower price/valuation and provides the greatest protection for investors but is the most restrictive if there will be multiple fundraisingrounds.
Weighted-average anti-dilution is also a form of economic dilution protection and gives an investor the right to acquire shares at a price that accounts for the difference in the old and new prices and is more company-friendly than full ratchetanti-dilution.
Under full ratchet anti-dilution, when a shareholder converts its preferred shares into ordinary shares, the conversion price of its preferred shares will be reduced to reflect the share issue price of the new round. This means that a preferred shareholder can convert its preference shares at the new, lower price. If the shareholder holds ordinary shares, additional shares will often be issued after the new round to make it whole. In both cases, the investor will receive more shares for its initial investment to ensure its stake in the company is notdiluted.
Under weighted-average anti-dilution, the conversation rate equals a weighted average of the prior and new share issuance price. If this case, the SHA should include a formula to calculate the weighted average share price based on the 1) amount raised by the company before the additional fundraising round and 2) the average price per share compared with the subsequent capital raise and lower share price. While a weighted average formula will not protect investors from dilution to the same extent as full-ratchet, it will mitigate theeffect.
The typical formula used in weighted average anti-dilution provisions is asfollows:
CP2 = CP1 x (A+B) /(A+C)
Where:
CP2 = Conversion price immediately after new issue of shares
CP1 = Conversion price immediately before new issue of shares
A = Number of shares of common stock deemed outstanding immediately before new issue of shares
B = Total consideration received by company with respect to new issue divided by CP1
C = Number of new sharesissued
Anti-dilution clauses exist to protect external investors and are often at the expense of founders, prior unprotected external investors or other shareholders. They are not ideal for the non-beneficiaries of the anti-dilution provisions, but the reality is that most serious and experienced investors will expect anti-dilutionprotections.
Because anti-dilution provisions can cause limitations on a company’s future fundraising, they can be structured as a ‘pay-to-play’ provisions. This operates to protect investors from dilution only if they participate in subsequent rounds of capital raising. Investors that do not participate do not receive anti-dilution protections. This benefits both the company and the investors because it encourages all investors to continue to fund thecompany.
Under a more punitive variation of pay-to-play, an investor’s failure to participate in a future capital raise (whether dilutive or not) will cause that investor’s preferred shares to be converted into common shares. Consequentially, the investor will not only lose anti-dilution protection but also any liquidation preferences and other special rights attached to its preferredshares.
Another alternative anti-dilution approach is the issuance of springing warrants to investors that participate in dilutive financing. Springing warrants allow investors that participate in a dilutive financing to purchase that number of additional shares of common stock allocable to them as calculated using the applicable anti-dilution formula for a nominalsum.
Founders of a company do not typically include complex anti-dilution provisions in an initial SHA (other than preemptive rights). Such terms are usually negotiated, if not dictated, by external investors and are dependent upon the relative bargaining power of the parties. They are not designed to protect founders but act as a safeguard for savvy investors. Anti-dilution provisions constitute one of the numerous inducements often necessary to satisfy investors and mitigate their risks in investing their money in a company that requirescapital.
