Why are anti-dilution provisions important?

Dilution is a natural part of fundraising, however, in a down round, the value of an investor’s stake in a company will be reduced (or diluted) if a new investor pays a lower price per share for its investment than the original investor paid in an earlier round of funding.

Anti-dilution provisions assist in ensuring that an investor’s ownership is not disproportionately or excessively diluted when new investors come on board. In essence, they give early investors confidence that their initial investment will maintain a certain level of value and influence, in exchange for assuming the initial risk of investing in the company’s infancy.

Where a company issues additional shares to new investors at a price that is lower than the price paid by previous investors, any previous investors that have anti-dilution rights will have the right to receive additional shares at no or minimal cost to compensate them for their economic dilution. The burden for any fall in the company’s valuation is, therefore, usually placed on the shoulders of the non-investor class (such as founders and management), rather than being shared equally by all shareholders.

Types of anti-dilution protections

There are two main types of anti-dilution protection:

1. Full ratchet

A full ratchet adjustment will compensate the protected investor as if its initial subscription price per share was the same as the down round subscription price. Put simply, we consider how many shares the protected investor would have received had it paid the down round price when subscribing for its shares.

For example, if an investor initially bought shares at R10 per share, and the company issues shares at R5 per share in a down round, the investor’s subscription price would be re-based as if it had paid R5 per share initially, not R10, and the investor would receive the number of additional shares as it would have originally received based on the R5 per share price.

2. Weighted average rachet

This is a more common and less aggressive approach, often favoured by founders or management, arguing that the down round price should not be looked at in isolation. This formula requires us to consider the amount of fresh shares issued in the down round in the context of the company’s overall share capital. As this method looks at the actual effect of the issue of new shares across the company’s share capital, it is much more equitable to the investee company and its other shareholders compared to the full ratchet.

In essence, having regard to the size of the funding round, this method uses a weighted average of the old and new share prices to calculate a new, adjusted price for the investor’s shares. This new price is then used to determine how many additional shares an investor will receive, protecting it from being diluted fully. 

Another less well-known ratchet is a performance ratchet, designed to incentivise founders and management. The effect of a performance ratchet is that the percentage of the company’s equity held by management will vary according to the performance of the company, rising if performance targets are met and falling if they are not. The performance measure for this type of ratchet can be based on either profits or, more commonly, the realisation proceeds in the event of an exit, whether by way of a sale or listing of its shares on an exchange.

The principal reasons for using a performance ratchet include: (i) to align management’s interests with those of the investors and incentivise management to drive the company’s performance; and (ii) to bridge the gap between management’s optimistic performance forecasts and investors’ more conservative projections during pricing negotiations.

Key takeaway: Negotiating anti-dilution provisions

Anti-dilution provisions are often a serious point of contention during negotiation between investors and an investee company, and founders may be hesitant to grant anti-dilution protection, as it may make future fundraising more difficult. Investors, on the other hand, are mandated to protect their investment. The type and strength of the anti-dilution provision will depend on the specific circumstances of the deal, the stage of the company, and the negotiating power of the parties involved.

Understanding anti-dilution provisions is essential for anyone involved in venture capital or private equity. So, whether you’re a founder or an investor in this space, reach out to us to help you protect your investment!