Acknowledgment of dilution: Overview, definition, and example
What is acknowledgment of dilution?
Acknowledgment of dilution refers to a provision in an agreement where an investor, shareholder, or party recognizes that their ownership stake, rights, or equity could decrease (dilute) due to future actions taken by the company, such as issuing additional shares or securities. Dilution typically occurs when a company raises new capital by offering more shares, which increases the total number of shares outstanding and reduces the percentage of ownership held by existing shareholders.
The acknowledgment of dilution serves as an understanding or agreement that the investor or shareholder is aware of and accepts the possibility of their ownership percentage being diluted in the future.
Why is acknowledgment of dilution important?
Acknowledgment of dilution is important because it provides transparency and ensures that all parties involved are aware of the potential consequences of actions that may reduce their ownership percentage. It is commonly used in venture capital, private equity, and corporate finance agreements, where investors might agree to the possibility of dilution in exchange for the opportunity to invest in a growing business.
For businesses, having this acknowledgment clause helps prevent disputes with shareholders or investors in the future, as they have agreed to the possibility of dilution. For investors, it ensures that they are aware of the risks associated with their investment and that the company may raise additional funds or issue more shares, potentially affecting their stake.
Understanding acknowledgment of dilution through an example
Imagine an early-stage investor in a tech startup who holds a 10% stake in the company. The company plans to raise additional capital by issuing more shares to new investors. As part of the investment agreement, the investor signs a clause acknowledging that their ownership percentage could be diluted if the company issues new shares. The investor agrees to this understanding in exchange for the opportunity to invest in the startup.
In another example, a shareholder in a public company owns 5% of the company's outstanding shares. The company decides to issue additional shares to fund a new acquisition. As a part of the shareholder agreement, the shareholder acknowledges that their percentage of ownership could decrease due to the new issuance of shares.
An example of an acknowledgment of dilution clause
Here’s how an acknowledgment of dilution clause might appear in an agreement:
“The Investor acknowledges that the Company may issue additional shares, securities, or other equity instruments in the future, which could result in the dilution of the Investor’s ownership percentage. The Investor agrees to accept such dilution and recognizes that the value of their investment may be impacted as a result.”
Conclusion
Acknowledgment of dilution is a crucial provision in investment and shareholder agreements, ensuring that all parties are aware of the potential for ownership dilution in the future. By clearly addressing this issue upfront, businesses and investors can avoid misunderstandings and ensure transparency regarding the impact of new share issuances or capital-raising activities. This clause provides protection for both the company and its stakeholders by establishing mutual understanding and managing expectations around ownership changes.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.