Anti-dilution clauses: An investor’s resource for the down round

When raising capital, there are many complex terms, clauses, provisions, and other conditions that can be found written in investment agreements. One of these is the anti-dilution clause. Although, initially this clause may intimidate some entrepreneurs or – much worse– may seem irrelevant to them, the reality is that it is extremely important. This especially true when there is a down round: when a company starts offering additional shares for sale at a lower price than had been sold in the previous financing round.

To understand this type of clause and its origin, it is important to address the complexity of determining the valuation of a company.

Valuation

Regardless of size, whether it is a large or small company, the valuation dilemma is and always will be an issue to be negotiated when raising capital. Determining the valuation of a company is a complex process. However, it is even more complicated in early-stage investments, where it usually requires a long negotiation between investors and the company. Marked more by subjective than objective elements, the main characteristics to evaluate to determine the investment at this stage are:

  • Quality of the management team  
  • Size and maturity of the market 
  • Uniqueness of technology
  • Stage of product development 
  • The competitive landscape
  • Previous post-money valuation
  • Reputation of the investors in the company, etc.

The earlier the stage of the company, the more complicated it is to know its real valuation, since the endless number of factors that affect or trigger the success of the company will only appear over the years. The problem with not knowing the valuation is that for investors this increases uncertainty, which is already high when it comes to venture capital.

What is the anti-dilution clause?

Anti-dilution clauses are intended to protect the investor in the event that the invested company issues new capital at a price per share lower than that previously paid by the investor.

With such uncertainty in the valuation at early stages, most investors try to make the investment increase in value. If this is not possible, investors seek to protect themselves in the event of a future round of financing at a lower value (“down round financing ”). As a general rule, the higher the investor’s input valuation (“pre-money valuation”), the greater the risk and, therefore, the more necessary it will be for the investor to incorporate this type of protection mechanisms in their favor. As exceptions there can be many due to the niche, the potential or the existing rounds.

At the time of investment, confidence is placed in the project expecting the greatest outcome, but investors also have this type of mechanism to avoid the greatest number of losses. In any case, when we talk about dilution within a capital increase we are referring to two different, though connected, circumstances:

  • Share dilution, derived from the potential reduction in the shareholding of the initial investor as a result of the entry of new investors; and
  • Economic dilution, derived from the reduction in the economic value of the initial investor’s shareholding, when the new investors acquire the new shares at a price lower than that paid by the initial investor.

Types of anti-dilution clauses

The clause is activated at the moment in which there is a new round of investment at a new (lower) valuation. For this to happen there must be an offer that sustains the new valuation. At that moment the investor gains the right to obtain additional shares in accordance with the conditions as agreed.

To understand the practical operation of each type of clause, I will explain the most common clauses below:

1. Weighted Average Price:

The most common anti-dilution clauses are the weighted average price. Through this mechanism, a new average price is calculated for the investor (always lower than the investor’s initial entry price). The total amount invested by the investor divided by the new average price will determine the number of total shares to which he is entitled and, therefore, the number of additional shares that the investor must receive.

This mechanism seeks to neutralize the negative impact of the economic dilution of the investor from the previous series (1), but without reaching the same price per share as the price paid by the investor of the next series (2). To calculate this new price per share of series A, a weighting is made between the value of the company before the down round and the amount of the dilutive round, taking into account the price per share before and after the round.

The formula to calculate the new weighted average price per share of the series (WAa) would be the following:

WAa = [(PPSa x PMS) + (PPSb x NS)] / (PMS + NS)

Where:

PPSa = Price per share of the series (1)

PMS = Number of shares in the pre-money (that is, before the down round)

PPSb= Price per share of the series (2)

NS = New shares of the series (2) issued in the down round

Although this type of clause is one of the most common, there are many investors and entrepreneurs who consider it to be a clause that complicates operations and may involve high legal costs.

2. Full ratchet:

The full ratchet formula is much simpler than the weighted average price formula. It is a more protective formula for the investor but perhaps too aggressive for the company. 

According to the NVCA’s model term sheet, full ratchet anti-dilution means that during a down round,  “the conversion price [of preferred shares from the previous round] will be reduced to the price at which the new shares are issued.”

The full-ratchet mechanism is the most protective formula for the investor, but also the most dilutive for ordinary shareholders (among which are the founders), since it involves the free delivery of a greater number of shares.

3. Pay to play:

Sometimes the mechanisms referred to in the previous sections are combined with what is called the pay to play in favor of the company. In other words, the investor will only be able to enjoy his anti-dilution right if he continues to participate in the new rounds, usually setting quantitative limits.

Founders Tip

To this clause you can add a section that is generally known as anti-dilution exclusions. Obviously, from the perspective of the company (and the employer), more exceptions are better, among them would be assumptions in which the clause would not apply can be added.

Anti-dilution provisions are almost always part of funding, so understanding the nuances and knowing what to negotiate is an important part of the entrepreneur’s toolkit. We recommend that you don’t get hung up on trying to eliminate anti-dilution provisions, but instead focus on (a) minimizing their impact and (b) creating value for your business after funding so they never come into play

Conclusion

Anti-dilution clauses provide investors with a very effective mechanism to minimize the negative impact that funding rounds at lower valuations may imply on their investment. The determination of the specific clause to use will depend to a great extent on each assumption and, in particular, on the initial valuation and the capital structure of the company.

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