What is Anti-Dilution Protection?

Anti-dilution protection matters because it can affect how ownership, voting rights and economic outcomes shift if a company later raises money at a lower valuation.

In a venture capital financing, anti-dilution rights offer protection against subsequent issuances of stock at a lower price. Venture capital investors typically receive preferred stock with various negotiated rights and preferences, which usually includes anti-dilution protection.

Ideally, the value of a company will increase over time, and subsequent issuances of stock will have a corresponding increase in issue price. However, various factors could negatively influence stock price, and companies may need to raise money at a lower valuation in the future. An anti-dilution adjustment effectively lowers the price of existing investors’ stock to account for the decrease in value of the company.

Typically, anti-dilution adjustments increase the ratio at which preferred stock converts to common stock. Preferred stock is convertible into common stock at the election of the holder, or automatically upon certain events, such as an IPO. The conversion ratio is equal to the original issue price of a share of preferred stock, divided by the “conversion price” (as calculated below). The initial conversion price typically equals the original issue price, so the conversion ratio typically starts out at 1:1.

Most economic and voting rights of preferred stock are determined on an “as converted to common basis”, based on the conversion ratio. This means that 1 share of preferred stock entitles the holder to a number of votes equal to the number of shares of common stock that 1 share of preferred stock converts into, or to receive a payout based on such number of shares of common stock, regardless of whether the preferred stock has actually converted to common stock. An anti-dilution adjustment may change the conversion ratio to, for example, 1:2. In that case, each such share of preferred stock counts for 2 votes and is, in many circumstances, entitled to receive payouts equal to the amount payable on 2 shares of common stock.

What are Typical Anti-Dilution Terms?

Conversion Price Calculation: As noted above, the conversion ratio is calculated as follows:

An anti-dilution adjustment increases the conversion ratio by decreasing the conversion price, though the method for decreasing the conversion price may vary. Typical calculation methods are described below.

Broad-Based Weighted Average:  The most common anti-dilution calculation is referred to as a broad-based weighted average adjustment. This adjustment sets the conversion price somewhere in between the original issue price of the existing preferred stock and the issue price of the newly issued shares, calculated as a weighted average price, taking into account all shares previously issued and the new issuance. The typical formula for calculating the new conversion price is as follows:

Where:

• A = the total number of shares of the company issued prior to the new issuance
• B = the number of new shares that would be issued if the issue price were equal to the current conversion price (i.e., the total new investment amount divided by the current conversion price)
• C = the number of new shares that will actually be issued

Full Ratchet:In rare cases, preferred stock will be entitled to a full ratchet adjustment, meaning that the new conversion price will be equal to the issue price of the newly issued shares. This results in a higher conversion ratio than a broad-based weighted average calculation, entitling a holder of each preferred share to more shares of common stock.

Exempt Issuances: Certain issuances of stock will not result in an adjustment to the conversion price, even if the stock is issued at a lower price than the existing preferred shares. These issuances may include shares issued to service providers, shares issued as a dividend, shares issued in connection with an acquisition or IPO, and shares issued in connection with a licensing transaction or strategic partnership. There may be some negotiation around which issuances are exempt, and whether such issuances require approval of the Board of Directors to be exempt.

Waivers: Anti-dilution adjustments may be waived by the existing investors. Existing investors may choose to waive adjustments if this is necessary or helpful for the company to obtain additional financing, which may ultimately result in a better outcome for all investors.

How is an Anti-Dilution Adjustment Calculated?

The following is an example of how to calculate an anti-dilution adjustment, illustrating the difference between a broad-based weighted average adjustment and a full ratchet adjustment.

Assume that a company has issued Series A Preferred Stock at an Original Issue Price = $1.00 per shares, and the company has a total of 1,000,000 shares of stock currently outstanding. No prior adjustments have been made, so the Series A Conversion Price = $1.00. The company now proposes to issue 500,000 shares of Series B Preferred Stock at an Original Issue Price = $0.50 (i.e., the company will receive a $250,000 investment). Using the above formulas, the new conversion price and conversion ratio of the Series A Preferred Stock will be calculated as follows. As the calculations show, each form of adjustment increases the number of common shares the Series A Preferred holder is entitled to receive, but the broad-based weighted average adjustment results in a lower ratio (and thus fewer common shares) than the full ratchet adjustment.

Broad-Based Weighted Average:

Full Ratchet:

Key takeaway: Anti-dilution provisions can materially affect ownership, voting rights and economics in later financing rounds, so companies and investors should review the adjustment method, exceptions and waiver mechanics carefully when negotiating these terms.