What is Dilution Protection?
As an Investors, you always look to hold shares that continue to grow in value. Dilution refers to the scenario where the ownership percentage of existing shareholders of a company decreases when new company shares are issued. It may also occur when a company’s stocks option holders namely, company employees or stakeholders of other optionable securities, exercise their options.
Given both above-mentioned scenarios, the number of outstanding shares increases, resultantly reducing the ownership percentage of existing shareholders, diminishing the value of their stakes. This leads to the need for Dilution Protection.
For the investor’s protection, certain contractual provisions are put into place that seeks to regulate a corporation’s power when it comes to reducing a shareholder’s stake after subsequent investor rounds or post-issuance of new equity. This is referred to as Dilution Protection. Also referred to as anti-dilution protection, these provisions are very common in venture capital funding agreements.
It is applicable when a company’s actions have the potential to diminish the overall percentage claim of stakeholders on the assets of the company. In other words, it is a provision that prevents the reduction of an early investor’s stake from diminishing in value post succeeding funding rounds or due to the course of certain events.
Example of Dilution Protection
For instance, an investor with an initial stake of 30% before a company initiates subsequent funding round, 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 15%. This would also lower the EPS (earnings per share), as the total number of shares has now increased. In such a scenario, the company is required to first offer discounted shares to the stakeholder, under the contractual provisions of Dilution Protection.
How does Dilution Protection work?
Dilution protection is applicable through Anti-dilution protection provisions that protect investors against the dilution of their equity ownership or the loss in value of their holding stake, by acting as a buffer. Under these provisions, companies are obligated to first offer discounted shares to the early investors and stakeholders. Dilution Protection allows to preemptively mitigate the dilution of stakeholders’ overall stake in the company’s ownership.
With regards to preferred shareholders of venture capital deals, cheaper issuance of new stock in the market is likely to cause a dilution of existing stock ownership. Provisions of anti-dilution mitigate the loss of stock value by adjusting the conversion price between convertible securities, keeping the investor’s original percentage of the ownership intact.
Conversion price refers to the price per share at which convertible security - corporate bonds or preferred shares, can be converted into common stock. For instance, the dilution protection provision will dip the conversion price of a convertible stock, if a company decides to sell more shares at a lower rate.
Criticism of Dilution Protection
A popular provision to entice investors to participate in risky ventures is when many companies use the dilution protection clause. It is common among early-stage startups, during their initial funding rounds. In many such cases, there is a high probability that the companies do not sustain long enough to seek multiple rounds of fundraising.
While this may allow early-stage startups to sometimes secure sufficient funding in the initial rounds, it may also prove to act as a hindrance for the startup to acquire investors during later rounds, as they may not be able to enjoy the same level of protection on their shares. Seeing this as a major drawback, associated venture capitalists may not be willing to offer the dilution protection clause to their early investors, to mitigate hindering subsequent funding rounds and ensure the odds of promoting the company’s success in the long term.
Types of Dilution Protection Provisions
As outlined in the funding and investment agreements of a company, anti-dilution provisions shield convertible stock or other forms of convertible security by tweaking their conversion price.
Dilution protection provisions allow for two approaches to calculating the new conversion price, namely: Full Ratchet and Weighted Average
The two types of provisions mainly differ in their aggressive nature of defending the percentage of ownership of the existing investors.
The full ratchet approach intends to adjust the conversion price of the existing preferred shares to the price of the new shares to be issued in subsequent rounds. This would mean that the prices are adjusted to match the lowest sale price being offered. Therefore, if an investor holds preferred shares in a company at a conversion price of $10, agreed under the full ratchet dilution provision, they would be able to buy twice as many shares, if the company decides to issue new shares at a lower conversion price of $5.
Under similar circumstances, but protected under the weighted average approach of dilution protections, companies determine the new conversion price to offer their convertible securities to existing investors. They use a formula, wherein the old conversion price, the number of shares outstanding before the new issue, considerations received with regards to the new issue and the total number of new shares issued are all accounted for.
The formula is given as follows:
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.
Upon comparison of the two approaches, the full ratchet approach is concluded to be more beneficial to the owners of preferred shares, as it allows them to convert their shares at the lowest available price. The weighted average method, on the other hand, helps to protect some value of the preferred shares. The conversion price determined by the former approach will always be better than that calculated by the weighted average formula.