What Is Anti-Dilution Protection?
Anti-Dilution Protection is a safeguard mechanism for venture capital (VC) investors that helps protect their ownership percentage in a company from being diluted when new shares are issued at a lower price than the original investment.
How Dilution Occurs
Dilution occurs when a company issues additional shares, typically during subsequent funding rounds or stock offerings, which results in a decrease in the ownership percentage of existing shareholders.
Why Is Anti-Dilution Important?
Anti-Dilution Protection is essential for VC investors as it ensures that the value of their investment is not significantly reduced by subsequent financing rounds or down-rounds, which could negatively impact the investor’s ownership stake and voting power.
What Are Different Types of Anti-Dilution Protections?
Price-based Anti-Dilution:
Price-based anti-dilution protection focuses on adjusting the conversion price of the investor’s preferred shares when new shares are issued at a price lower than the initial investment.
Contractual Anti-Dilution:
Contractual anti-dilution protection involves a pre-agreed provision in the investment contract that outlines the specific mechanism for adjusting the conversion price or issuing additional shares to the investor to counter the effects of dilution.
How Does Price-based Anti-Dilution Protection Work?
Two Types of Price-based Anti-Dilution Protection:
Full-Ratchet Anti-Dilution Protection:
In full-ratchet anti-dilution, the conversion price of the investor’s preferred shares is adjusted to the price of the newly issued shares, regardless of the price difference. This means that the investor receives additional shares to compensate for the decrease in share value.
Weighted Average Anti-Dilution Protection:
Weighted average anti-dilution protection takes into account both the price and the number of newly issued shares. The conversion price is adjusted based on a formula that considers the old and new share prices, as well as the number of shares outstanding before and after the issuance.
How Does Contractual Anti-Dilution Work?
Contractual anti-dilution protection entails a predefined formula or mechanism agreed upon in the investment contract. This mechanism outlines how the conversion price will be adjusted or how additional shares will be issued to the investor in response to dilution events.
Anti-Dilution Protection versus Pro Rata Right
Anti-Dilution Protection and Pro Rata Right are two different concepts. Anti-dilution protection aims to protect the investor’s ownership percentage from dilution, whereas Pro Rata Right gives the investor the option to maintain their ownership percentage by participating in future financing rounds and purchasing a proportionate amount of new shares.
