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How does anti-dilution work? Frequently asked questions

Inconsistent market and economic factors can lead to a drop in values and share prices of companies. This in turn leads to some companies having to raise new financing at values lower than what they were valued in previous rounds of financing. This is commonly called a ‘down round ’.

For obvious reasons, down rounds are not good news for existing (previous round) investors – their investments are now less valuable than they were. This is where anti-dilution protection becomes valuable. Anti-dilution clauses are standard in investment documents / shareholders’ agreements.  

In this list of FAQs, we cover the most common questions asked about anti-dilution protection and how it works.  

1. What is dilution?

Shareholding is calculated by dividing the number of shares an investor holds to the total number of shares a company has issued. It is usually expressed as a percentage. Dilution is a reduction in an investor’s shareholding percentage. Higher the number of total shares issued (denominator), the greater the dilution

2. How does a down round affect shareholders / investors not covered by anti-dilution protection? 

Let’s understand this with an example.

If a seed investor (Investor A) has invested INR 10,00,000 at INR 100 per share, this means A holds 1,000 shares in a company. If the share price in a subsequent round reduces to INR 50 (because the company has lost value) and an investor B now invests the same amount, B will get 2,000 shares. Assuming that the total issued shares in the company was 10,000 at the end of seed round and B is the only investor in the subsequent round, the total shares issued as on date will be 12,000. 

In this case, A’s shareholding percentage dilutes from 10% (1,000*100/10,000) to 8.3% (1,000*100/12,000) more than it would have if B had invested by paying the same price as A i.e., at share price INR 100, B would have received 1,000 shares resulting in a total issued shares of 11000, bringing A’s shareholding to 9% (1,000/11,000*100). Hence downrounds, places A at a disadvantage with the increase in dilution.

Hence, to avoid this extent of dilution, investors seek protection in all investment deals.

3. What is anti-dilution?

Anti-dilution is a valuation protection clause negotiated into shareholders’ agreements by investors. The clause protects the investors’ value if there is a down round by being issued additional shares. Investors protected under this clause can enforce their right from undue dilution by receiving additional shares based on the price per share of the new round.

4. If a company has issued convertible securities and anti-dilution protection is applied, are actual shares issued to compensate for dilution?

Typically, no. The conversion ratio (agreed at the time of investment) in which one unit of convertible security converts to equity is adjusted. However, in some cases, additional shares may also be issued.

5. How is the price per share for issuing new shares calculated?

There are two methods of calculating the price per share for issue of new shares when the anti-dilution clause is enforced: (a) Full ratchet and (b) Weighted average, which could be narrow-based or broad-based weighted average

6. What is the difference between full ratchet and weighted average anti-dilution?

Full ratchet anti-dilution protection equates the price per share paid by the previous round investors to the price per share in the down round. Here, the conversion price is adjusted downwards to match the price in the new round. At the time of conversion, this results in issuing additional shares to adjust for the difference.

In a weighted average calculation, the price per share of the additional shares to be issued is calculated based on considering all shares and convertible instruments issued by the company, including stock options. Thus, the adjusted price takes into account a higher number of shares as issued. Accordingly, the number of shares to be issued to protected investors in the previous round is calculated or their conversion ratio is adjusted.

7. What is the difference between narrow-based and broad-based anti-dilution methods?

The difference lies in the formula used to arrive at the adjusted price between the two weighted average methods.

The broad-based method includes all securities issued, including convertibles, on a fully diluted basis. Here, all convertible instruments, including warrants and options, are assumed to have converted to equity.

The narrow-based weighted average method includes only equity and preference shares that convert to equity. Options and warrants are excluded from the formula.  

8. Which method of anti-dilution is more preferable for the founders and investors? Why?

Full ratchet is the most investor friendly and broad-based weighted average is the most founder friendly.

Full ratchet results in a higher number of additional shares being issued to investors compared to what investors get under a weighted average method.

Founders prefer the weighted average calculation, since the impact of dilution on them is relatively less.  

9. Will anti-dilution always result in dilution of founders’ shareholding?

Anybody who is not protected under the anti-dilution clause suffers the impact of dilution. Most often, it is the founders. Employees who become shareholders after they exercise their stock options will also be affected, since they have no anti-dilution protection.

10. If anti-dilution clause is enforced, what is the impact on the stock option pool?

A stock option pool is a kitty of shares set aside to issue to employees, consultants, and advisors. As the number of issued shares goes up, which happens in a down round, the shareholding percentage of the pool (in a fully diluted cap table) drops.

11. What happens to stock options when there is a down round?

A down round does not affect the stock option holder. It is only an impact seen on the shareholding percentage of investors. However, the stock options will now be less valuable. This is because employees make money from the difference between the market value of shares and the exercise price. A drop in the share price (and no change to exercise price) will provide lesser return to employees once the options are exercised. This may result in options becoming less attractive to employees

12. Is the exercise price of options adjusted to compensate for a fall in share price in a down round?

No. Unless the stock option plan allows for such an amendment, the exercise price is not adjusted. Employees will still have to pay the exercise price which may now seem a high price to pay to acquire lower-value shares.

13. Are there any exceptions to anti-dilution protection?

Yes – there are instances when anti-dilution protection is not triggered:

(a) Stock options issued to employees and advisors.

(b) Shares issued to strategic partners approved by investors. For example, if a company has a contract with a vendor who is bringing in value, then along with payment of cash, shares may also be issued. Shares issued under such contracts are not covered by the anti-dilution clause.

(c) Shares issued when investors exercise the right to maintain capital.

(d) Shares issued when warrants and other convertible instruments are converted.

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