Anti-Dilution

Anti-dilution provisions are those put in place to protect holders of convertible securities from the dilution of share value as a result of various corporate events. These include stock dividend splits, the issuance of additional common stocks, and the distribution of cash or properties, among other things.

Dilution clauses are significant because they offer investors a safety net. It shields the existing investors from the economic dilution that may come from a down round. In other words, the provisions prevent the dilution or loss of value of their equity holding interests. They prevent the stockholders from losing their investment value.

Key Takeaways                                                               

• Anti-dilution clause safeguards investors from value declines brought on by common stock's dilution in funding rounds. It shields the existing investors from the economic dilution that may come from a down round.
• Full ratchet and weighted average are the two popular forms of anti-dilution protection. 
• In the ratchet anti-dilution approach, the price of conversion is decreased in one go to the new round's price (regardless of the price and quantity of new stock sold).
• Weighted-average anti-dilution is in which the conversion price is modified by a formula that considers both the conversion price and the number of new shares issued.

Anti-dilution clause protects the value of investors' shares from declining in the event of common stock's dilution in funding rounds. Any security that one can convert into another security, often shares of the issuer's common stock, is a "convertible security." These securities typically include debt instruments or shares of preferred stock.

Convertible securities often convert into a specific number of shares of common stock. This is determined by dividing the initial purchase price (which sometimes includes accrued but unpaid interest or dividends) by a set conversion price.

The price at which each share of the underlying security will be received upon conversion is known as the conversion price. The value of the shares received through conversion will be diminished (or diluted) if further shares of the underlying security are issued at a price lower than the conversion price. This is true, especially if there are no adjustments on the convertible security holders. Therefore, acts taken by an issuer that increase the quantity (or decrease the value) of shares of its common stock outstanding would likewise reduce or "dilute" the value of the conversion.

The goal of investment rounds is to raise the company's valuation so that each round's pre-money valuation is higher than the one before it. More rounds equate to more investors, which means that more people should split the shares between them. Investors typically don't mind the drop in ownership as long as the company's valuation grows because the higher valuation increases the value of the shares they are currently holding. Investors prefer to be safe in the case of a downturn in which the company's valuation drops.

This is where anti-dilution protection comes to the rescue. The voting power and control of the corporation are additional factors for investors to worry about dilution. Control and voting power are typically related to the type and number of shares held by a shareholder. If their stake in the company receives dilution, investors and even founders may find themselves at a disadvantage because they are lesser in number. Investors often favor a provision known as "anti-dilution provisions" to safeguard against this happening.

Full ratchet and weighted average are the two popular forms of anti-dilution protection.

#1 - Full Ratchet 

The full ratchet anti-dilution method reduces the conversion price to exactly what was paid per share in the dilutive issuance, effectively enabling the holders of convertible securities to receive stocks at a lower price. In theory, the investor gets complete protection by this strategy from economic dilution from the initial investment. This is because, following the adjustment, the securities received upon conversion will have the same overall value as the initial investment. However, regardless of the extent of the dilutive offering, common stockholders could experience a significant dilution.

#2 - Weighted-Average

The weighted-average approach reduces the conversion price to the weighted-average price per share of the issued (or deemed issued) securities both prior to and in the dilutive issuance. In general, all outstanding stock (or deemed outstanding) before the dilutive issuance is treated as having been issued at the conversion price that was there immediately before the dilutive issuance.

In contrast to the other approach, the weighted-average method offers a better adjustment if there is issuance of a higher number of shares of stock at a lesser price. Similarly, it provides a less significant adjustment if there is issuance of a smaller number of shares at a smaller price.

One can calculate it using the weighted average anti-dilution formula given as follows:

CP2=CP1*(A+B)/ (A+C)

Where,

CP2 indicates the conversion price after the down round

CP1 indicates the conversion price before the down round

A indicates the fully diluted capitalization of the company prior to the downturn

B indicates the amount received as a consideration in the downturn round (divided by CP1)

C indicates the number of shares of stock issued in the down round.

Check out these examples to get a better idea:

Example #1 - Dilution 

Suppose ABC, a company, has a current valuation of 1,000,000. It has three investors, X, Y, and Z, with ownership rates of 40%, 30%, and 30%, respectively. Suppose another investor Alpha comes in with another 1,000,000; the company's total valuation will now be 2,000,000. This means that Alpha will own 50% of the shares in the new valuation round, and the other investors' X, Y, and Z ratios will also reduce to half the existing rates, which will be 20%, 25%, and 25%, respectively. This reduction of the value of ownership is termed dilution. 

Example #2 - Weighted-Average

Let's say Company XYZ wanted to raise $500,000 in the second round of fundraising, where investor B (second investor) paid $ 1. The previous investor, A, who has anti-dilution protection, had bought the stocks at $2. Since the value has decreased from $2 to $1, the second round is a downturn round. The details are as follows. 

Using the weighted average anti-dilution formula CP2=CP1*(A+B)/ (A+C)

We plug CP1=$2 per share 

A=1,000,000(previous round’s)

B=250,000(500000/$2)

C=500,000 (issued in the down round)

CP2= CP1*(A+B) / (A+C)

CP2= 2*1,250,000/1,500,000

CP2=1.67

New conversion ratio=$ 2 (early investors price share)/ new conversion price (1.67) =1.20:1 

This new conversion ratio decides the common shares received at the down round. The higher the ratio, the higher number of common shares received. A will now get the option to convert their share for $1.67 instead of $ 2.

Here are the main differences between the two: