What are carveouts to anti-dilution protection?
Takeaway: "Carveouts" are a standard and essential part of your charter that exempts certain stock issuances, like those for your employee option pool, from triggering your investors' anti-dilution rights, giving the company needed operational flexibility.
While anti-dilution protection is a standard right for preferred stockholders, it cannot be a blunt instrument that penalizes the company for routine and necessary corporate actions. If every single share issuance at a lower price triggered a complex anti-dilution adjustment, it would create an administrative nightmare.
To solve this, the section of the company's Certificate of Incorporation that defines the anti-dilution rights also contains a critical set of "carveouts" or exceptions. These carveouts list specific types of stock issuances that are explicitly exempt from the anti-dilution calculation, even if they occur at a price lower than what the investors paid.
These carveouts are a standard and non-controversial part of any venture financing term sheet. They are essential for giving the company the operational flexibility it needs to run its business without constantly triggering a complex repricing of its preferred stock.
Standard and Expected Carveouts
The list of standard carveouts is highly conventional across the venture capital industry. Every well-drafted charter will exclude the following types of issuances from the anti-dilution formula:
Shares Issued from the Employee Option Pool: This is the most important carveout. It allows the company to grant stock options to its employees, directors, and consultants at a lower fair market value (as determined by the 409A valuation) without triggering anti-dilution protection for the preferred stockholders. Without this carveout, a company's entire equity compensation program would be unworkable.
Shares Issued in Connection with an Acquisition or Strategic Partnership: The company needs the flexibility to use its stock as a currency to acquire another company or to cement a major strategic partnership. This carveout allows for those M&A and strategic transactions.
Shares Issued to Lenders or Landlords: This allows the company to issue a small amount of equity (often in the form of a warrant) to a bank or a landlord as a "sweetener" for a loan or a lease, which is a common practice.
Shares Issued as a Result of a Stock Split or Stock Dividend: These are purely administrative changes to the capital structure that affect all stockholders equally and should not trigger an anti-dilution adjustment.
Why Carveouts are Critical
These carveouts are not "loopholes"; they are essential for the normal functioning of the business. They ensure that the anti-dilution protection is triggered only by its intended purpose: a bona fide "down round" equity financing.
By carving out these standard and necessary corporate actions, the charter allows the company to hire talent, make strategic acquisitions, and manage its business without the constant fear of triggering a complex and unnecessary repricing event. Reviewing this list of carveouts with your counsel is a key part of the term sheet negotiation to ensure it aligns with market standards.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.