Anti-Dilution Clauses in Term Sheets: Meaning and Best Practices
Anti-dilution clauses, as the name suggests, are investment provisions that protect investors from dilution should a company they invest in issue shares to new investors at a lower price than they invested at. Anti-dilution clauses are crucial as they protect investors from the often consequential loss of value they would experience otherwise.
Take the following simplified example:
Company A has 100 outstanding shares priced at $2 each. Its valuation (share price * shares outstanding) is $200.
Investor A invests $40 to acquire 20 newly issued shares.
Company A now has 120 outstanding shares (the 100 initial shares plus the 20 units issued to Investor A) and a post-money valuation of $240 (share price of $2 * new total shares outstanding).
After the raise, Investor A owns 16.67% of the company (20 / 120 shares) valued at $40.
A year later, due to traction issues and a general economic downturn, Company A’s perceived value falls significantly. In a bid to raise money for a potential pivot, it issues 20 new shares to Investor B priced at $1 each, a ‘down round.’
Company A’s total outstanding shares now stand at 140 (100 initial shares + 20 shares issued to Investor A + 20 shares issued to Investor B).
Investor B owns 14.29% of the company (20 / 140 shares) valued at $20.
Investor A also owns 14.29% of the company (20 / 140 shares), now valued at $20, down from his initial $40 investment.
The down round leads to a 50% loss in value for Investor A.
Due to the potential for such losses when a startup’s fortunes change, investors have increasingly pushed for the inclusion of anti-dilution clauses to protect their investments.
How does anti-dilution work?
Anti-dilution provisions state that where a company raises a future round at a lower valuation than an existing investor invested at, the earlier round’s preferred-to-common stock conversion price will be retroactively adjusted to reflect the lower valuation. For instance, using the initial example: if Investor A first purchases shares at $2 and, later, Investor B is issued shares at $1, Investor A’s holdings would be repriced to reflect the new $1 share price.
While without anti-dilution protection Investor A would own only 14.29% of the company valued at $20, with anti-dilution protection, his $40 investment would entitle him to 40 shares instead of the 20 he originally received.
This retroactive repricing is made possible through the structure of convertible preferred stock and common stock, securities commonly offered during startup fundraising rounds.
Preferred vs. Common Stock
Common stock refers to the most basic unit of ownership in a corporate entity. Common stockholders enjoy typical shareholder rights, including the right to vote and receive dividends, but they are the last to be paid in a liquidation, behind creditors, bondholders, and preferred shareholders.
Preferred stock, on the other hand, is a class of shares that gives holders a higher claim to dividends or assets than common shareholders, but a lower claim than bondholders and other creditors. Preferred shareholders generally enjoy enhanced protections in liquidation scenarios but often have limited or no voting rights. Some preferred shares, convertible preferred stock, allow the holders to convert their preferred stock to common stock at a predetermined conversion rate. It is this conversion feature that makes anti-dilution possible.
Anti-dilution under the hood
A typical anti-dilution clause goes something like this:
Antidilution Provisions: The conversion price of the Series A Preferred will be subject to a [full ratchet/broad-based/narrow based weighted average] adjustment to reduce dilution in the event that the Company issues additional equity securities at a purchase price less than the applicable conversion price. In the event of an issuance of stock involving tranches or other multiple closings, the antidilution adjustment shall be calculated as if all stock was issued at the first closing. The conversion price will also be subject to proportional adjustment for stock splits, stock dividends, combinations, recapitalizations, and the like.
While initially wordy, the concept is straightforward. Still using our earlier example:
Investor A purchases preferred stock worth $40, convertible into 20 common shares at $2 per share.
When the company later raises a down round pricing common stock at $1 per share, Investor A’s preferred stock immediately becomes convertible at $1 instead of $2. His total entitlement increases to 40 shares instead of 20.
Anti-dilution operates by updating the conversion price at which preferred shares convert into common shares.
Types of anti-dilution clauses
There are two primary types of anti-dilution clauses:
Full ratchet clauses
Weighted average clauses
Both will be examined below.
Full ratchet
Full ratchet clauses provide the strongest level of investor protection. They require that if a down round occurs, the investor’s preferred shares be immediately convertible at the new, lower price regardless of how many new shares are issued.
Full ratchet clauses shield investors from significant dilution but are often considered aggressive by founders.
Weighted average
Because full ratchet clauses usually provide that an earlier round be immediately repriced to the later, cheaper round regardless of how many new shares are issued, they are often construed as excessively harsh on founders. Weighted average clauses on the other hand help cure this malady. By using a weighted average formula that takes into account the amount of shares outstanding and the amount of new shares issued, the weighted average approach results in a more moderate reduction in the conversion price, allowing investors to convert their securities into additional common shares, but not as many as they would under a full ratchet provision.
There are two variations of weighted average clauses:
Broad-based weighted average: calculates ALL shares outstanding including those given to employees and unexercised as options (is the current industry standard).
Narrow-based weighted average: only includes shares given to investors in the calculation.
The formula for calculating weighted average anti-dilution is:
C2 = C1 x (A + B) / (A + C)
Where:
C2 = new conversion price
C1 = old conversion price
A = number of outstanding shares before a new issue
B = total consideration received by the company for the new issue
C = number of new shares issued
The bottom line
Anti-dilution clauses, while technical, remain important tools frequently used by investors to protect their investments in an increasingly volatile startup ecosystem. By ensuring an investor does not suffer disproportionate dilution when a company’s value declines, these clauses help balance the risk profile of early-stage investing.
However, where anti-dilution clauses are included, it is crucial that they are fair to both investors and founders. Founders should model the impact of each structure before signing. In most cases, a broad-based weighted average provision strikes a reasonable balance between investor protection and founder equity preservation.
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