The anti-dilution clause allows investors to retain their shareholding percentage if new shares are issued.
- Anti-dilution provisions are clauses that allow investors the right to maintain their ownership percentages in the event that new shares are issued.
- Dilution refers to a shareholder’s ownership decreasing as a result of new shares being issued.
What is an Anti-Dilution Provision?
nti-dilution provision measures are introduced to protect investors’ and stakeholders’ interests, most of which have been associated with the company from an early stage. Provisions ensure that when a company issues new shares on the market, investors retain their right to maintain an original shareholding of more than 50%. Rights to protect the interests of preferred shareholders are most closely related to anti-dilution provisions.
The issue of new shares by the company may reduce the value of the ownership percentage of existing investors and stakeholders. When more shares are in flow than when the stock option holders or stakeholders holding other optionable securities exercise their options, investors and early-stakeholders risk losing out on the value of their current claim to ownership of the company. There is, therefore, a need for dilution protection, which is geared towards the interests of early investors.
Anti-Dilution Provision at Work
In particular, for preferred shareholders in venture capital deals whose shareholdings can be reduced if subsequent issues of the same stock are listed at lower prices, dilution is a complicated problem to solve. Anti-dilution provisions could prevent this by modifying the conversion rates between convertible securities, such as company bonds or preferred shares and common stock. An anti-dilution clause can preserve the investor’s original shareholding percentage.
Types of Anti-Dilution Provisions
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.
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
When are Anti-Dilution Provision Used?
Most companies that issue convertible securities use anti dilution provisions. The provisions are significant in the venture capital area because a number of funding rounds have already taken place. As they allow convertible securities to remain at a higher cost, they are also used to encourage companies to maintain their financial targets.
How will the Anti-Dilution Provision Affect your Business?
It’s important to note that the anti-dilution provision does not apply to everyone. The parties would not negotiate for the inclusion of an anti-dilution clause in some situations. This means that the guarantee provided by anti-dilution clauses can come at the cost of additional investors. This is a significant issue given that the vulnerable shareholder also serves as the founder or key employee of the company.
This is why they may lose motivation to contribute to the company’s success when their shares are diluted too much. Investors with knowledge won’t wish to reduce the entrepreneurs’ drive to grow their businesses. However, when several investors are involved and multiple funding rounds are launched, anti-dilution clauses can significantly impact a company’s business process.
FAQs
What is an anti-dilution clause?
An anti-dilution clause is a provision in a contract, typically found in investment agreements, that protects an investor from dilution of their ownership stake in a company in certain circumstances, such as future rounds of financing.
Are there any downsides to anti-dilution clauses?
While anti-dilution clauses protect investors, they can be disadvantageous for existing shareholders, including founders and early employees, as they may experience more significant dilution in subsequent financing rounds.
Why do investors seek anti-dilution protection?
Investors seek anti-dilution protection to preserve the value of their investment in the face of future fundraising rounds at lower valuations. It helps ensure that their ownership percentage remains relatively constant, protecting them from dilution and maintaining their initial investment value.
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