Anti-dilution provisions are clauses built into convertible preferred stocks and some options to help shield investors from their investment potentially losing value. When new stock issues hit the market at a lower price than that paid by earlier investors in the same stock, equity dilution can occur. Anti-dilution provisions are also called anti-dilution clauses, subscription rights, subscription privileges, or preemptive rights.
What are Anti-Dilution Provisions?
Anti-dilution provisions protect an investor’s equity stake from dilution. A company may issue new shares with a round of equity financing or let its options exercised by their owners. In either case, the total number of shares outstanding will increase, while the investor still owns the same number of shares. Therefore, the investor’s percentage ownership in the company will decrease.
In some cases, the cash that a company receives for shares may offset the effect. However, usually, there will be a decline in the value of the outstanding shares. An anti-dilution provision grants an investor the right to convert their preferred shares at the new price.
Imagine you own preferred stock that you purchased for $20 per share. If the company that issued the shares goes public and issues shares at $15, the value of your investment would’ve gone down. An anti-dilution provision would protect investors from drops in value due to dilution.
When are Anti-Dilution Provisions Used?
Anti-dilution provisions are used by most companies when issuing convertible stock. The provisions are especially prominent in venture capital investing, as many rounds of financing are used. They are also used to further incentivize companies to maintain financial targets, as it allows convertible securities to remain at higher costs.
Types of Anti-Dilution Provisions and How They Work
There are two types of anti-dilution provisions – full ratchet and weighted average.
1. Full Ratchet
A full ratchet provision would protect investors who own options or convertible securities. The provision allows the investors to convert at the lowest sale price offered. Therefore, they are protected if the new offering price is lower than the conversion price on the investor’s shares.
Example
Assume an investor owns preferred shares in Company ABC, with a conversion price of $10, attached to a full ratchet anti-dilution provision. However, Company ABC issues more shares at a conversion price of $5. The original conversion price of $10 would be lowered to $5. At the same price, the investor would then be able to purchase twice as many shares.
2. Weighted Average
The weighted average method uses a formula to determine the new conversion price.
New Conversion Price = O x (A + B) / (A + C)
Where:
- O – Old conversion price
- A – Shares outstanding before new issue
- B – Consideration received with new issue
- C – New shares issued
Example
Imagine that during a first offering, 1,000 preferred shares are issued at $5 per share, and are convertible at a 1:1 ratio. Now, imagine the company issues another 1,000 shares; however, at a new price of $3 per share. To determine the new conversion price under the weighted average method, you would insert the numbers into the formula above.
Therefore, the new conversion price would = $5 * (2,000 + $3,000) / (2,000 + $5,000) = $3.57. Owners of the first issue of preferred shares would now be given the option to convert their shares for $3.57, rather than $5.
FAQs
How Do Anti-Dilution Provisions Protect Investors?
Anti-dilution provisions protect investors by adjusting the conversion price of their convertible securities (such as preferred stock or convertible debt) when new shares are issued at a price lower than the price they originally paid. This adjustment increases the number of shares the investor can convert their securities into, thereby preserving their ownership percentage and investment value.
What Is Weighted Average Anti-Dilution?
Weighted average anti-dilution is a more moderate approach compared to full ratchet. It adjusts the conversion price of the investor’s convertible securities based on a formula that takes into account both the number of shares previously issued and the number of new shares issued at the lower price.
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