What is anti-dilution protection?
Takeaway: Anti-dilution protection is a standard investor right that adjusts the conversion price of preferred stock downward in a "down round," protecting early investors from being unfairly diluted by a subsequent financing at a lower valuation.
When a venture capitalist invests in your startup, they are not just buying a certain number of shares; they are buying a certain percentage of your company at a specific price. They are making a bet that the value of the company, and therefore the value of their shares, will go up over time. But what happens if the company stumbles and is forced to raise its next round of financing at a lower valuation? This is a "down round," and it can be incredibly dilutive to all existing stockholders.
To protect themselves from this scenario, investors receive anti-dilution protection. This is a standard and critical feature of preferred stock that automatically adjusts the conversion price of their shares downward in a down round, effectively giving them more shares of common stock to compensate for the lower valuation.
How Anti-Dilution Works: The Conversion Price Adjustment
Remember that preferred stock is convertible into common stock. The "conversion price" is initially set at the price the investor paid for their stock in their financing round. Anti-dilution protection works by re-calculating and lowering this conversion price if a future financing occurs at a lower price. A lower conversion price means that each share of preferred stock now converts into more than one share of common stock.
There are two main types of anti-dilution protection:
Broad-Based Weighted-Average (The Market Standard): This is the more common and founder-friendly formula. It adjusts the conversion price based on a "weighted-average" formula that takes into account the number of new shares being issued in the down round and their lower price. The formula is "broad-based" because it includes all outstanding common stock and options in the calculation. This results in a moderate, fair adjustment to the conversion price.
Full Ratchet (The Aggressive, Founder-Unfriendly Version): This is a much more severe and punitive formula. A "full ratchet" provision adjusts the conversion price of the existing preferred stock all the way down to the price of the new stock sold in the down round, regardless of how many new shares are issued. This can be massively dilutive to the founders and is considered a very aggressive, non-market term that should be strongly resisted in most situations.
Why Does This Matter?
Anti-dilution protection is a fundamental part of the risk allocation between founders and investors. It ensures that the early investors who took the most risk are not unfairly wiped out by a subsequent, lower-priced financing round. While the math can be complex, the principle is simple: it is a mechanism to adjust the ownership percentages to reflect a new, lower valuation, protecting the investment of your financial partners while still keeping the founders and employees in the game. For any standard venture deal, you should expect to see a broad-based weighted-average anti-dilution provision.
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.