Hi startup superstars!
It’s May (already) - the temperatures are on the rise, the days are getting longer and we want to make sure you have enough food for thought to power through Q2. That’s why we’re back with another instalment of our series on the most common terms you’ll find in an investment terms sheat. Today, we’re looking at anti-dilution provisions.
First, let’s recap what we know about dilution. Equity dilution happens when a company issues new shares. As a result, existing shareholders' ownership percentage goes down. Simply put, if you have 10 % with 100 shares and the company issues 100 more shares, your ownership drops to 5 %.
Anti-dilution provisions help investors maintain their stake in the company if there’s a down round (meaning company valuation is lower than when they invested). Let’s illustrate on an example. You’re an existing investor who purchased company shares at EUR 100 per share. Now, the company is raising new funds at the price of EUR 50 per share. Without an anti-dilution provision, you wouldn’t be compensated for the dip in value. With an anti-dilution provision, you get compensated for the down-round by getting additional shares.
Technically, there’s two ways around this. Full ratchet anti-dilution means that existing shareholders benefit from the lowest sales price as the conversion ratio. This can be pretty costly for founders because it means that the existing shareholders have to be given new shares as if they invested at a lower valuation in their investment round. That’s why weighted average anti-dilution is a more common option. The weighted average method uses a relative formula to calculate the conversion ratios in a down round - and produces a more balanced outcome.
The choice of an anti-dilution provision dictates how many new shares are to be issued to an existing investor in a down-round. Simply put, if you go for full ratchet, you will need to issue new shares at zero additional cost to investors which can be pretty expensive for the founders. Weighted average anti-dilution creates a better balance between the rights of investors and founders.
Here’s a couple of tips when considering (and drafting) anti-dilution provisions:
The anti-dilution provision is a yet another example of a term that plays a key role in balancing the rights of founders and investors. On one hand, it’s reasonable for investors to protect their percentage ownership against down rounds. On the other, the founders are justified in making sure they don’t issue new shares at zero additional cost.
Want to learn more about anti-dilution provisions or other investment strategies? Reach out to our team for personalized advice and stay connected with us on LinkedIn for more insights.
Bye for now!