Anti-dilution adjustments: Overview, definition, and example
What are anti-dilution adjustments?
Anti-dilution adjustments are provisions in investment agreements that protect investors from the dilution of their ownership percentage in a company due to subsequent issuances of shares or securities. These adjustments are typically included in the terms of preferred stock or convertible securities, ensuring that if the company issues additional shares at a price lower than the original investment, the investor’s shares are adjusted to maintain the same proportion of ownership. The purpose of anti-dilution provisions is to safeguard investors' interests in the event of future financing rounds where new shares may be issued at a discounted price.
Why are anti-dilution adjustments important?
Anti-dilution adjustments are important because they help maintain the value of an investor's stake in a company, especially in early-stage investments. When a company issues more shares at a lower price, the existing investors could see the value of their holdings reduced. Anti-dilution clauses protect these investors by adjusting the conversion rate of their shares or giving them more shares in return for their original investment. This provision is essential for attracting investors, particularly in startup environments, where the company may need additional rounds of financing and the risk of dilution is higher.
Understanding anti-dilution adjustments through an example
For example, an investor purchases 100,000 shares of a startup at $10 per share. If the company later issues additional shares at a price of $5 per share in a subsequent financing round, the investor's 100,000 shares would be worth less, as the value of the company has decreased. However, if the investor's shares have an anti-dilution adjustment clause, the terms of the investment would ensure that the investor’s shares are adjusted to reflect the lower price. In this case, the investor might receive additional shares so that their percentage of ownership in the company is not reduced.
In another example, a convertible note holder agrees to convert their debt into equity at a $1 million valuation. If the company later issues additional shares at a lower valuation of $500,000, the anti-dilution provision would adjust the conversion price of the note to reflect the lower valuation, ensuring the note holder’s ownership percentage is not diluted by the new lower-price issuance.
An example of an anti-dilution adjustment clause
Here’s how an anti-dilution adjustment clause might appear in an investment agreement:
“If the Company issues additional shares of Common Stock at a price lower than the price paid by the Investor for the Preferred Stock, the conversion price of the Preferred Stock shall be adjusted on a weighted-average basis to reflect the lower issuance price. The adjustment will be made automatically, and the Investor’s ownership percentage will be protected from dilution due to this new issuance.”
Conclusion
Anti-dilution adjustments are vital provisions that help protect investors from losing value in their investments when a company issues additional shares at a lower price. These provisions help maintain investor confidence, especially in early-stage companies that may need future rounds of funding. By ensuring that investors' ownership percentages are not significantly reduced due to future dilutive events, anti-dilution adjustments contribute to fairer investment terms and a more predictable investment environment.
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.