What is anti-dilution protection?
Takeaway: Anti-dilution adjustments protect investors in the event the company raises money at a lower valuation after they already invested at a higher valuation. This is not done by issuing more shares but actually is done by adjusting the price at which the preferred stock converts to common stock.
Venture capital investors may face the risk of dilution when startups raise additional funding at a lower price than the existing investors paid for their stock. To mitigate this risk, investors seek anti-dilution protection, a provision included in startups’ charters that protects their ownership stake from being significantly diluted in future financing rounds as a result of having more stock sold at a lower price. In this post, we will explore the concept of anti-dilution protection, its various forms, and its significance in the context of venture capital investments.
What is Anti-Dilution Protection?
Anti-dilution protection is a provision in startups’ charters designed to shield investors from the dilution of their ownership stake in a company when it issues new shares at a lower price per share than the price at which the investors originally invested. This protection is typically included in the terms of preferred stock investments, ensuring that the investor's ownership percentage and economic interests are preserved.
Types of Anti-Dilution Protection
There are two primary forms of anti-dilution protection:
Broad Based Weighted Average Anti-Dilution: Weighted average anti-dilution is the most common and moderate form of protection. It takes into account both the price and the number of new shares issued in the dilutive financing round. The investor's conversion price is adjusted based on a weighted average formula that considers the original price, the new lower price, and the number of shares issued at each price. This method generally results in a less significant adjustment to the conversion price and is considered more balanced between the interests of investors and the company.
Full Ratchet Anti-Dilution: Full ratchet anti-dilution is the most severe and investor-friendly form of protection. Under this provision, if a company issues new shares at a lower price than the investor's original purchase price, the investor's conversion price (the price at which their preferred shares convert into common shares) is adjusted downward to match the new lower price. This adjustment results in the investor receiving more common shares upon conversion, thereby preserving their ownership percentage.
When is Anti-Dilution Protection Used?
Anti-dilution protection is commonly used in venture capital investments, particularly in the following scenarios:
Startup Financing Rounds: When startups raise multiple rounds of funding, there is a risk that new shares may be issued at a lower price than the price paid by existing investors. In these situations, anti-dilution protection helps shield existing investors from the adverse impact of the lower valuation on their investment.
Corporate Actions: Anti-dilution protection may also be triggered by certain corporate actions, such as stock splits, stock dividends, or the issuance of stock options. These actions can dilute existing investors' ownership stakes, making anti-dilution protection a valuable safeguard. However, many of these corporate actions are carved out as exempted from anti-dilution protection and, as a result, do not typically trigger anti-dilution adjustments.
In practice, anti-dilution protection can be and frequently is waived by investors. Typically, companies will be communicative with their investors about the prospect of raising money at a lower valuation and will negotiate with the investors to waive their anti-dilution protection. This can include offering the investors the right to purchase additional shares at the lower valuation.
Conclusion
Anti-dilution protection is an essential component of venture capital investments, providing investors with a safety net against the potential erosion of their ownership stake in a company due to future financings or corporate actions. By understanding the different types of anti-dilution protection and their implications, both investors and startups can negotiate investment terms that strike a balance between protecting investor interests and supporting the company's growth and long-term success.