What is an Anti-Dilution Provision?

Issue of new shares by a company can lead to the diminishing of the value of the ownership percentage of existing investors and stakeholders. This is referred to as Dilution. In scenarios of new issues or the event of the stock-option holders, or stakeholders of other optionable securities exercising their options, the number of outstanding shares increases because of which the value to investors and stakeholders with an early-stake stand to lose out on the value of their existing claim on company ownership. This creates the need for Dilution Protection which caters to the interests of early investors.

What Is an Anti-Dilution Provision?

To seek the protection of investor and stakeholder interests, typically those who have been associated with the company since the early stages, dilution protection provisions are implemented. This is the definition of the anti-dilution provision. The provision clauses ensure investors retain the right to maintain their original ownership percentage in the company, in the circumstances the company issues new shares in the market. Anti-Dilution provisions largely are associated with rights for protecting the interests of preferred shareholders.

Anti-Dilution Provisions at Work

A common clause in venture capital funding agreements, Anti-Dilution provisions are greatly used as a popular provision to entice large investors to participate during early-stage funding rounds. A common understanding in such cases is the high possibility that such risky ventures may not be able to sustain long enough to seek subsequent rounds of funding due to which the clauses may never be applicable.

As per the Anti-Dilution provision's definition, in events that may cause an increase in the number of outstanding shares namely -

  • A scenario of the new issue of shares by the company
  • In case the company’s employees and stakeholders exercise the convertible security option, resultantly causing a drop in value for the early-investors equity ownership percentage, the clause act as a buffer.

In such circumstances, the company is obligated to first make an offer to the existing investors for discounted shares. The Anti-Dilution provisions preemptively mitigate the dilution of the companies’ ownership stakes as held by the early-stage investors and stakeholders.

The anti-dilution provision clauses are incorporated into convertible security options and preferred shares, protecting the investors from the possibility of their investments losing value in the future due to multiple events, previously mentioned. Convertible preferred stock refers to types of securities that can be converted into common stock at a price, known as the conversion price. Convertible securities may be corporate bonds or preferred shares.

An investor with a 10 per cent stake in a company, implies the investor holds 10 of the 100 outstanding shares in the company. If the company, initiates a new issuance of another 100 shares in the market, the investors' ownership percentage would get diluted by half to 5 per cent.

As the number of outstanding shares is increased with the new issue of shares for the round of equity financing, introduced at a lower price, it reduces the percentage of investor ownership. New equity issued at a cheaper price also impacts the earning per share, thereby lowering it, resultantly impacting the investment value of existing stakeholders. This loss in value of ownership percentage is referred to as Dilution and is protected by anti-dilution provisions. The anti-dilution provision allows for the investor to convert their preference shares into common stock thereby keeping their ownership stake intact in terms of value.

Types of Anti-Dilution Provisions

As mentioned in the funding agreements and investment contracts, the anti-dilution provision prevents loss of investment value to the shareholders, when new shares are issued in the market at a lower rate than in previous rounds of equity funding. This is done by offering the right to preferred shareholders to convert their convertible preferred shares at a conversion price, ensuring their percentage of company ownership is not diluted. The conversion price can be determined through two approaches, under two types of anti-dilution provisions as referenced in the investment agreements. These types are Full Ratchet and Weighted average.

The Full Ratchet approach adjusts the conversion price of convertible preferred securities to match the new price of the issues released to the market. This benefits investors, as it implies that the conversion price can be equivalent to the lowest price of the shares being offered. For Instance, if an investor holds preference shares at $10 per share, as per full ratchet anti-dilution provisions, if the company issues new shares at $5 per share, the investor has the right to buy twice as many shares, by converting their stake of preferred shares to common stock.

The weighted average approach determines the new conversion price through the use of a formula accounting for the original conversion price, the conversion price of the new issues, the total number of outstanding shares before a new issue, considerations received concerning the new issue, and the total number of new shares issued.

The formula is as below:

NP = P * (A+B)/((A+C)

Where:

  • NP - New Conversion Price
  • P - Old conversion Price
  • A - Total Number of outstanding shares before a new issue
  • B - Total considerations for new issues by the company
  • C- Total number of new shares issued.
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Frequently Asked Questions Expand All

The anti-dilution provision is mostly used by companies issuing convertible security options to their stakeholders. The clauses are commonly used by venture capital firms in their funding agreements, where typically multiple funding rounds are a common occurrence. Anti-Dilution Provisions are also used to incentivize companies to maintain their financial targets, ensuring convertible securities are continued to be valued higher.

An investor with a stake of 30% implies the investor holds 30 shares in the company with 100 outstanding shares. However, with the issuance of 100 new shares, the investor’s existing ownership would be diluted by half, that is 15%. This would also lower the EPS, as the total number of shares has now increased. This is referred to as dilution. Offering convertible securities at a conversion price to the early investors will enable them to retain their original percentage stake of ownership in the company. This is an example of anti-dilution.

Anti-dilution provisions are common in venture capital agreements and incorporated into the convertible preferred stocks and options.