If you're raising funds for a startup or investing in one, the chances are that you've come across anti-dilution rights. As discussed in our previous article, investors often use various mechanisms to protect their investments in early-stage companies. Anti-dilution rights are a common feature in venture capital term sheets, designed to protect investors in the event that a portfolio company raises money at a lower valuation in a later funding round – known as a down round.
While these protections are important from an investor's point of view, they can also have serious implications for founders and ordinary shareholders. In this article, we explain what anti-dilution rights are, the different types that exist, and what they mean in practical terms.
What are anti-dilution rights?
Anti-dilution rights are clauses in investment agreements that aim to protect investors from a reduction in the value of their shareholding in the event that a company issues new shares in a down round. This is usually achieved by the investor being issued, at no or minimal cost to the investor, additional shares to maintain (as far as possible) the value of their (pre-down round) shareholding.
Consequently, anti-dilution rights do not necessarily prevent dilution, but rather redistribute the impact of dilution on certain shareholders, most commonly, the founders, employees and founding shareholders.
Types of dilution: what's the difference?
To understand how anti-dilution works, it's important to distinguish between two kinds of dilution:
1. Ownership dilution
This refers to the reduction in your ownership and/or voting rights in a company when new shares are issued. Suppose you own 10,000 shares in a company with 100,000 shares outstanding - giving you a 10% ownership stake. If the company issues an additional 50,000 shares in a new funding round, and you don't purchase any of them, your ownership stake would fall to approximately 6.67% - this is the effect of ownership dilution.
2. Economic dilution
This refers to the reduction in share value when a company raises money in a down round. Suppose you invest in a company at a valuation of £10 million for a 10% ownership stake, your investment (put simply) is worth £1 million. The company later raises funding at a valuation of £7 million, and you decide to participate in the round to maintain your 10% ownership stake. Despite not being diluted from an ownership perspective, your investment is now worth £700,000 (10% of £7 million) - this is the effect of economic dilution.
Anti-dilution rights are primarily designed to protect against this second form of dilution by issuing investors with additional shares to 'compensate' them for the reduction in the value of their shareholding in a down round.
The main types of anti-dilution provisions
There are two main types of anti-dilution protection, being the full ratchet and weighted average mechanisms.
1. Full ratchet anti-dilution
Under a full ratchet mechanism, if a down round occurs, the investor's original investment is treated as though it had been made at the lower, new price. It doesn't matter how many new shares are issued or how much money is raised. In practice, this can result in the investor being issued a significant number of free (or minimal cost) shares, which will often be incredibly dilutive on the non-protected share classes (i.e. the founders, ordinary shareholders and option holders).
Whilst the most favourable mechanism for investors, full ratchet provisions are rarely used in UK venture capital transactions for this reason, but that is not to say they are redundant.
2. Weighted average anti-dilution
This is a more balanced and commonly used approach. Under the weighted average mechanism, the number of anti-dilution shares issued is based on both the price reduction and the number of new shares issued in the down round. In other words, the level of protection is proportionate to the size of the down round.
There are two main variations of this method:
- Narrow-based weighted average: the number of anti-dilution shares to be issued is based on the existing issued share capital only (ignoring options and convertible loan notes), meaning that the dilutive effect on non-issued (options/convertible) shares will be greater.
- Broad-based weighted average: the number of anti-dilution shares to be issued is based on the entire issued and unissued share capital, including options and convertible loan notes. Therefore, the broad-based weighted average methodology is more founder and employee-friendly.
Final thoughts
Anti-dilution rights are a standard feature in almost all institutionally led (non-EIS) investment transactions, as they offer important protection for investors taking early risks. However, they can significantly affect founders and other shareholders in the event of a down round.
If you're negotiating a term sheet or preparing for an investment round, it's essential to understand the mechanics of anti-dilution rights and how they could impact your (and your investors') ownership in the event of a down round.
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.
