What are carveouts to anti-dilution protection?
Takeaway: Standard carveouts to anti-dilution protection include stock and options issued to employees and consultants pursuant to equity incentive plans, shares issued when acquiring another company, shares issued in strategic partnerships, and shares issued to lenders in connection with bank loans. These are the most common carveouts but there are others.
Anti-dilution protection is an essential provision in venture capital investment agreements, helping safeguard investors from the dilution of their ownership stake in future financing rounds. However, it is important to note that not all issuances of new shares trigger anti-dilution protection. Startups' charters typically include a list of exempted issuances, which do not activate anti-dilution adjustments. In this post, we will discuss the most common exemptions to anti-dilution protection and the rationale behind these exceptions.
Common Exemptions to Anti-Dilution Protection
The following issuances are typically exempted from anti-dilution protection in startups’ charters:
Stock Options and Employee Incentive Plans: One of the most common exemptions to anti-dilution protection is the issuance of shares through stock option or employee incentive plans. These plans are designed to attract, retain, and motivate employees, aligning their interests with the company's success. Exempting these issuances from anti-dilution protection enables startups to implement effective incentive plans without triggering adjustments that may negatively impact other investors.
Shares Issued in Mergers and Acquisitions: When a startup acquires another company or merges with it, new shares may be issued as part of the transaction. These issuances are often exempted from anti-dilution protection to facilitate the completion of the transaction and to avoid adjustments that could complicate negotiations.
Shares Issued in Strategic Partnerships: Startups may enter into strategic partnerships or joint ventures with other companies, which may involve the issuance of new shares. To encourage collaboration and strategic growth, these shares are typically exempted from anti-dilution protection.
Shares Issued in Conjunction with Debt Financing: Startups may issue shares as part of debt financing transactions, such as convertible debt or warrants. These issuances are often exempted from anti-dilution protection to facilitate raising capital through debt instruments without activating conversion price adjustments.
Shares Issued Pursuant to Previously Granted Rights: Startups may have granted rights to certain investors to purchase additional shares in the future, such as through warrants or convertible securities (e.g., convertible promissory notes or SAFEs). Shares issued pursuant to these previously granted rights are typically exempted from anti-dilution protection to honor pre-existing contractual obligations.
Rationale Behind Exemptions
There are several reasons why startups' charters include exemptions to anti-dilution protection:
Encourage Growth and Collaboration: Exemptions allow startups to pursue growth opportunities, strategic partnerships, and acquisitions without being constrained by the potential impact of anti-dilution adjustments.
Attract and Retain Talent: By exempting employee incentive plans from anti-dilution protection, startups can create compelling equity-based compensation packages to attract and retain key talent.
Simplify Capital Structure: Exempting specific issuances from anti-dilution protection can help simplify a startup's capital structure and avoid the complexity associated with adjusting conversion prices.
Facilitate Fundraising: Exemptions make it easier for startups to raise capital through various financing methods, such as debt or strategic investments, without triggering anti-dilution adjustments that could negatively impact existing investors.
Conclusion
While anti-dilution protection is crucial for investors, it's essential to understand the common exemptions that allow startups to grow, collaborate, and raise capital without triggering adjustments. By being aware of these exemptions, both investors and startups can strike a balance between safeguarding investor interests and promoting the company's growth and success. Ultimately, it is important for all parties involved in venture capital investments to negotiate and agree upon anti-dilution provisions and exemptions that align with their respective interests and objectives. A clear understanding of these exemptions can contribute to a more productive relationship between investors and startups, fostering a collaborative environment that drives innovation and long-term value creation.