An investor invests in a startup with high growth expectations and a good exit in subsequent investment rounds. However, if the startup fails to meet these expectations and the valuation of the company dips due to any reason – be it low revenue, governance issues, or legal issues, the company will have to issue shares at a much lower valuation in the future investment rounds (as commonly referred to as 'down round') to sustain. This will result in the dilution of the shareholding of the existing investor and also a decrease in the overall value of their shares. Anti-dilution provisions are clauses that are meant to protect existing investors from future rounds at a valuation which is lower than the valuation in which they had invested.
Types of Anti-Dilution Protection
Broadly, there are two types of anti-dilution protection – full ratchet and weighted average methods.
Full Ratchet:
Full ratchet protection is a straightforward mechanism that lowers the previous round's price per share to the new round's price per share so that, in a subsequent down round, the existing investor will become entitled to additional shares, and their fully diluted shareholding percentage remains the same.
This method is most beneficial to the existing investor; however, it causes maximum damage to the promoter's stake and is thus sparingly used in general practice.
Weighted Average Protection:
Weighted Average protection, on the other hand, finds a middle ground, by taking into account both original and new share prices, and thus, 'averages out' the impact of such down round across all stakeholders.
The conversion price for the existing investor is determined in the following manner in this method:
CPN = CPO x (A+B)/(B+C)
CPN = New Conversion Price; CPO = Original Conversion Price; A = total number of shares immediately prior to the current round; B = total number of shares issuable to existing investor at CPO; C = total number of shares being issued in the down round
Weighted average protection may further be of two kinds—the broad-based approach, which is commonly used, takes into account all common outstanding shares while computing the new conversion price, while the narrow-based approach excludes options or warrants.
Hence, weighted average anti-dilution right is a fairer compromise than full ratchet, as it doesn't give the investor the lowest price possible but still adjusts the shares enough to compensate for the new lower valuation.
Beyond the formula – Complexities in implementation
As detailed above, the common way of exercising anti-dilution is the adjustment of conversion price (depending on the approach provided in the agreement).
However, this becomes a complex issue when the anti-dilution right is being exercised by a non-resident shareholder, and the Foreign Exchange Management (Non-Debt) Instruments Rules, 2019 ('NDI Rules') come into play.
Rule 21(2)(ii) of the NDI Rules requires that the price at which shares of an unlisted / private Indian company are issued to a non-resident, should not be less than the fair market value of such shares as determined by any internationally accepted pricing methodology.
Hence, as per the NDI Rules, neither the shares can be issued at NIL price to any non-resident equity investor, nor the conversion price can be readjusted below the fair market value at the time of issue of such convertible instrument.
To avoid such impediments, the initial issue price should be such to allow for a buffer and downward revision of the conversion price.
Conclusion
In a volatile market, anti-dilution protection acts as a crucial safety net for investors, preserving investor equity and fostering confidence in the business. If structured in the right manner, it can set a foundation for stable and shared growth for investors and founders.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
