Anti-dilution provisions: Overview, definition, and example
What are anti-dilution provisions?
Anti-dilution provisions are contractual clauses designed to protect existing shareholders from a reduction in the value or percentage of their ownership when a company issues new shares at a lower price. These provisions help ensure that early investors or shareholders maintain their proportional stake or financial value if additional shares are issued under unfavorable terms.
For example, if a startup raises a new round of funding at a lower valuation than before, anti-dilution provisions may adjust the ownership percentage of existing investors to prevent excessive dilution of their shares.
Why are anti-dilution provisions important?
Anti-dilution provisions are important because they protect investors from losing significant value when new shares are issued at a lower price. Without these provisions, early investors could see their ownership stake and investment value decrease when a company raises additional capital.
These provisions are commonly found in venture capital agreements, convertible notes, and preferred stock agreements. They help attract investors by providing reassurance that their equity interest will not be unfairly diluted if future financing rounds occur at a lower valuation.
There are two main types of anti-dilution protections:
- Full ratchet anti-dilution – Adjusts the conversion price of existing shares to match the lowest price at which new shares are issued.
- Weighted average anti-dilution – Adjusts the conversion price based on the number of new shares issued and their price, providing a more balanced approach to dilution protection.
Understanding anti-dilution provisions through an example
Imagine an investor buys shares in a startup at $5 per share. Later, the startup faces financial challenges and raises a new round of funding at $2 per share. Without anti-dilution provisions, the investor’s ownership percentage would shrink significantly.
With a full ratchet anti-dilution provision, the investor’s shares would be adjusted as if they had originally been purchased at $2 per share, granting them additional shares to compensate for the dilution.
With a weighted average anti-dilution provision, the investor’s conversion price would be adjusted based on the number of new shares issued at the lower price, offering partial protection while maintaining fairness for new investors.
Example of an anti-dilution provisions clause
Here’s how an anti-dilution provisions clause might appear in an investment agreement:
“In the event that the Company issues additional shares of stock at a price per share lower than the price paid by the Investor, the conversion price of the Investor’s preferred shares shall be adjusted according to the weighted average anti-dilution formula set forth in this Agreement.”
Conclusion
Anti-dilution provisions help protect investors from losing ownership value when a company issues new shares at a lower price. These provisions make equity investments more attractive by ensuring early investors are not disproportionately affected by future financing rounds. Businesses seeking investment should carefully structure anti-dilution provisions to balance investor protection with fundraising flexibility.
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.