1. Brief
Anti-dilution rights are critical for safeguarding the proportion of holding of early investors against dilution when additional shares are offered at a cheaper price. Popular in convertible securities, these features guarantee that the initial investment value is preserved by modifying the conversion price or issuing more shares to existing investors. There are two primary types: full-ratchet, which gives maximum protection, and weighted average, which adjusts the conversion price using a formula. There are some exceptions to these restrictions, such as employee stock ownership plans and mergers, which provide organizations with flexibility. Overall, anti-dilution policies increase confidence among investors, attract investment, and encourage enterprises to attain greater values, resulting in a healthier investment climate.
2. Introduction to Anti-Dilution Rights?
Anti-dilution protection is a provision in a company’s financing agreement that protects the interests of early investors in the event of subsequent issuances of new shares at a lower price. It aims to ensure that the value of the original investment is not diluted as a result of additional shares being issued at a lower price.
Anti-dilution protection is a predominant trait of convertible securities like convertible bonds and convertible preferred stock, and it is envisioned to safeguard initial investors from subsequent issuances of additional shares at a lesser price. It can, however, make it more challenging for a firm to obtain money by limiting the number of additional shares that can be offered as well as the amount at which they can be issued.
3. Types of anti-dilution provisions
Anti-dilution provisions are classified into two types: “weighted average” and “full-ratchet.” The weighted average technique changes the preferred stock conversion price to adjust for the depletion induced by the fresh issue of new shares. The full-ratchet approach, on the other hand, instantly changes the conversion price to the new reduced price, irrespective of the dilution created.
A. Full Ratchet Anti-Dilution Protection
Full-ratchet protection is an ideal choice for any investor since the existing investor’s ownership is modified in line with the decreased per-share price given as part of the down-round, i.e., by modifying the conversion price and conversion ratio of the securities owned by the investor.
B. Weighted Average Anti-Dilution Protection
The weighted average technique changes the preferred stock conversion price to adjust for the depletion induced by the fresh issue of new shares. There are two types of Weighted Average Anti-Dilution methods:
- Narrow-Based Weighted Average vs. Broad-Based Weighted Average
Weighted average anti-dilution safeguards are classified into two types: broad-based and narrow-based. They differ in the sorts of shares they consider while changing share prices through anti-dilution. Broad-based is more comprehensive than narrow-based, as the name indicates.
A broad-based weighted average takes into consideration all previously issued and presently existing equity. A narrow-based weighted average, on the other hand, simply takes into consideration all convertible preferred shares or general existing preferred shares convertible for a certain series.
The narrow-based weighted average generally excludes options, warrants, and shares that are issued by the company to provide incentives to the employees or any other person. For example, if the firm had an ESOP and early workers got options, such stock equivalents will not be included in the weighted average.
Adjusted Conversion Price = CP x (A + B) / (A + C), where:
| Variable | What it represents |
| CP | Present conversion price |
| A | Total outstanding shares on a fully diluted basis before down-round |
| B | Shares issuable for the amount raised in the down round at the CP |
| C | Number of shares issuable in the down round |
ILLUSTRATION
| Shareholder | Number of Shares
(On a fully diluted basis) |
Shareholding percentage |
| Founder | 25,000 | 50% |
| Investor | 20,000 | 40% |
| ESOP | 5,000 | 10% |
| Total | 50,000 | 100% |
The investor pledged 20,000 convertible securities at a per-share price of INR 100. Thus, the total sum invested by the Investor was INR 20,00,000.
| Shareholder | Number of Shares
(On a fully diluted basis) |
Shareholding percentage |
| Founder | 25,000 | 41.7% |
| Investor | 20,000 | 33.3% |
| New investor | 10,000 | 16.7% |
| ESOP | 5,000 | 8.3% |
| Total | 60,000 | 100% |
the company offers to issue 10,000 new shares at a price of INR 50 per share due to a decrease in the valuation of the Company to a new investor for INR 5,00,000. The non-existence of any anti-dilution protection goes against favour of the Investor: –
*Full Ratchet Anti-Dilution Protection
The conversion ratio will be changed to 1:2, and the conversion price of the investor’s shares will be reduced from INR 100 to INR 50. After the conversion happens, the Investor will get an extra 20,000 shares at no cost. The post-adjustment share capital table is as follows:
| Shareholder | Number of Shares
(On a fully diluted basis) |
Shareholding percentage |
| Founder | 25,000 | 31.25% |
| Investor | 40,000 | 50% |
| New investor | 10,000 | 12.5% |
| ESOP | 5,000 | 6.25% |
| Total | 80,000 | 100% |
*Broad-Based Weighted Average Anti-Dilution Protection
Adjusted Conversion Price = CP x (A + B) / (A + C), where:
| Variable | What it means | In our example (in INR) |
| CP | Present conversion price | 100 |
| A | Total outstanding shares on a fully diluted basis before down-round | 50,000 |
| B | Shares issuable for the amount raised in the down round at the CP | (10,000 x 50) / 100) = 5,000 |
| C | Number of shares issuable in the down round | 10,000 |
Adjusted Conversion Price = 100 x (50,000 + 5,000) / (50,000 + 10,000) = 91.6
The Investor’s ownership in the Company would be 20,000 *100 / 91.6= 21,835 and share capital would be:
| Shareholder | Number of Shares
(On a fully diluted basis) |
Shareholding percentage |
| Founder | 25,000 | 40.4% |
| Investor | 21,835 | 35.31% |
| New investor | 10,000 | 16.2% |
| ESOP | 5,000 | 8.1% |
| Total | 61,835 | 100% |
*Narrow-Based Weighted Average Anti-Dilution Protection
stock options that are not issued, warrants, or shares to be issued upon conversion/exercise of debt and other such securities are eliminated when estimating anti-dilution using this method, and only shares that are presently issued and existing are considered. As a result, in this case, the ESOP will not be computed.
Variable A will be equal to 50,000-5,000 = 45,000
Adjusted Conversion Price =100 x (45,000 + 5,000) / (45,000 + 10,000) = 90.91
The Investor’s ownership in the Company would be 20,000 *100 / 90.91=22,000 and share capital would be:
| Shareholder | Number of Shares
(On a fully diluted basis) |
Shareholding Percentage |
| Founder | 25,000 | 40.3% |
| Investor | 22,000 | 35.5% |
| New investor | 10,000 | 16.1% |
| ESOP | 5,000 | 8.1% |
| Total | 62,000 | 100% |
4. Effect by various mechanisms
Such adjustments, either through full ratchet or weighted average can be implemented through a variety of methods, such as
(a) free disbursement of new shares at the current price to the current investor to secure there percentage in the company,
(b) transfer of shareholdings from the founders to the current investor at the minimum acceptable value.
(c) in the event of convertible securities, by changing the conversion price to the prevalent price;
(d) buy-back of existing investor stocks by the firm; and
(e) by decreasing the sale proceeds of the promoters or other shareholders.
The most usually offered approach is still a conversion price adjustment.
4. Exception to Anti-dilution protection
The exception to an anti-dilution provision is a clause in a securities agreement that allows for a change to the terms of the agreement in certain specific circumstances. The purpose of an exception to an anti-dilution provision is to provide greater flexibility to the company and its management in making future equity issuances, while still protecting the rights of the preferred shareholders. The inclusion of exceptions can help ensure that the anti-dilution provision does not become overly restrictive and limit the company’s ability to raise capital in the future.
An exception to an anti-dilution provision may be included to provide an exemption from the adjustment mechanism in certain cases, such as a future issuance of shares to employees through an employee stock option plan or to investors in a future financing round. The exception may specify the types of issuances that are exempt from the anti-dilution adjustment, the number of shares that can be issued under the exception, and the conditions under which the exception may be invoked.
There are several exceptions to these provisions:
- Authorized but unissued shares: Anti-dilution provisions usually do not apply to shares that have been authorized but not yet issued.
- Employee Stock Options (ESOPs): ESOPs are often excluded from anti-dilution provisions as they are typically granted to employees at lower prices than the market price.
- Mergers and Acquisitions: Anti-dilution provisions do not apply to stock issuances in the context of mergers, acquisitions, or other business combinations.
- Preferred Stock Issuances: Anti-dilution provisions typically do not apply to issuances of preferred stock, as these are different types of securities with different rights and privileges.
- Financing Rounds: Anti-dilution provisions may not apply to issuances of new securities in connection with financing rounds.
- Equity Shares issued upon the exercise of options or upon the conversion or exchange of convertible securities or warranties.
- Holder has waived the requirement of Anti-Dilution Adjustment
It is important to remember that anti-dilution protection applies only when shares are offered at a lower than the price paid by current investors and not for each successive issue of shares. The rationale for this is that if shares are sold to succeeding investors at a greater price per share than the previous investors paid, even while their percentage shareholding in the firm decreases, the value of the shares owned by them rises.
5. Significance Of Anti-Dilution Provision
Most of the companies use Anti-Dilution provision to protect investors from losing substantive percentage of ownership in the company. The provisions are particularly noticeable in venture capital investing. This feature also serves to further incentivise corporations to meet financial objectives by allowing convertible securities to stay at higher prices. It allows investors to retain existing ownership percentages in the event that fresh shares are issued. Some significant points about anti-dilution provisions:
1. Protection of Ownership Stake: Anti-dilution clause protects the existing shareholders from the dilution of their percentage of ownership when new shares are issued by the company especially when issue at a lower price than the price at which it was issued to the existing shareholder. This is significantly crucial for early-stage investors or founders who may see their control and influence in the company decrease with each subsequent round of funding.
2. Value Preservation: The anti-dilution clause guarantees that the value of existing shares and the percentage of ownership of the shareholder does not reduce or diminish with the issuance of the new share by the company especially when new shares are issued at the lower price than the price paid by earlier investors.
3. Investor Confidence: Anti-dilution provisions enhance confidence of the investor by giving them safety against the impact of the subsequent funding rounds and issuance of the shares by the company. The enhanced confidence allows the investor to further participate and invest in the company.
4. Attracting Investment: Companies can use the anti-dilution clause as a method to attract more investment in the company. By offering safety against dilution, companies can make their shares more alluring to potential investors.
5. Incentive for Higher Valuations: This clause motivates the company to hunt for greater values in future investment cycles. Since any valuation below the existing valuation would trigger the anti-dilution adjustments, management is determined to guarantee that new shares are issued at or above earlier valuations.
5. Conclusion
Anti-dilution measures are critical tools for safeguarding investors’ equity shares from being diluted during successive rounds of funding. These safeguards ensure that the initial investors retain their proportional stake and value of investments, even if the firm issues additional shares at a reduced price. Anti-dilution provisions improve investor trust in the investment by aligning their interests with those of the firm, resulting in a more stable and appealing atmosphere for raising funds. Anti-dilution rights are highly negotiated in investment operations and it is important for both founders and investors to comprehend the criteria behind the calculation and the underlying effect of these terms before contractually committing to them.
