Anti-dilution: Overview, definition, and example
What is anti-dilution?
Anti-dilution refers to a provision in investment agreements, particularly in venture capital and shareholder agreements, that protects investors from the dilution of their ownership percentage in a company. This typically occurs when a company issues new shares, which increases the total number of shares outstanding and reduces the ownership percentage of existing shareholders. Anti-dilution provisions are designed to adjust the price or number of shares held by existing investors to maintain their percentage of ownership or to provide compensation for the dilution caused by the new issuance of shares.
There are two common types of anti-dilution provisions:
- Full ratchet anti-dilution: This adjusts the investor’s price per share to the price at which the new shares are issued, regardless of the number of shares issued. This provides more protection to the investor.
- Weighted average anti-dilution: This adjusts the investor’s price per share based on the weighted average of the new issue price and the previous price, considering the number of new shares issued. This is a more moderate approach that protects the investor without being as drastic as the full ratchet provision.
Why is anti-dilution important?
Anti-dilution provisions are important because they help safeguard investors’ interests when a company issues additional shares, often in the form of funding rounds or stock options. Without this protection, early investors could see a significant decrease in the value of their holdings and ownership percentage, especially in startups or growing companies.
For investors, anti-dilution provisions ensure that their stake in the company remains as valuable as possible even if the company issues more shares at a lower price. For companies, offering anti-dilution provisions is a way to attract investors by providing additional assurance that their investment will be protected against dilution.
Understanding anti-dilution through an example
Imagine an investor initially buys 1,000 shares in a company for $10 each, for a total investment of $10,000. Later, the company raises additional capital by issuing 2,000 new shares at $5 each. Without anti-dilution protection, the investor’s ownership percentage would be diluted because the company’s total shares outstanding have increased, and the value of each share is now lower.
However, with an anti-dilution provision in place, the investor may have their shareholding adjusted to maintain their original percentage of ownership. For instance, if the provision is full ratchet, the investor’s shares might be adjusted to match the new $5 price per share, increasing their share count to 2,000 shares to compensate for the dilution.
In another example, a company issues additional shares at a lower price, but under a weighted average anti-dilution provision, the investor’s price per share may be adjusted based on the weighted average of the new issue price and the original price, resulting in a less extreme adjustment than in the full ratchet case.
An example of an anti-dilution clause
Here’s how an anti-dilution clause might appear in an investment agreement:
“In the event that the Company issues additional shares at a price lower than the price per share paid by the Investor, the Company agrees to adjust the Investor’s shareholding or price per share to reflect the dilutive impact of such issuance. The adjustment shall be calculated using the weighted average method, taking into account the number of new shares issued and their price.”
Conclusion
Anti-dilution provisions are essential for protecting investors from the negative impact of dilution on their ownership and investment value. These provisions help investors maintain their percentage of ownership or value in a company, especially during subsequent funding rounds or when new shares are issued.
For investors, anti-dilution clauses provide a safeguard against losing control or value in their investment. For companies, offering anti-dilution provisions is an important way to attract investors and ensure their long-term participation, making the company more appealing for funding.
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.