What is Dilution?
Dilution occurs when a company issues new shares, reducing the ownership percentage of existing shareholders. This typically happens during fundraising rounds when new investors come on board, or through employee stock options, convertible securities, or mergers. Dilution can significantly impact an existing shareholder's control over the company and their share of future profits.
Imagine you own 10% of a company with 1,000 shares, meaning you hold 100 shares. If the company issues an additional 1,000 shares to new investors, the total number of shares becomes 2,000. Your 100 shares now represent only 5% of the company, reducing your ownership stake by half.
What is an Anti-Dilution Clause?
An anti-dilution clause protects existing shareholders from the adverse effects of dilution. These clauses adjust the conversion rate of convertible securities to ensure that existing shareholders maintain their proportional ownership in the company despite the issuance of new shares.
Types of Anti-Dilution Provisions
There are two main types of anti-dilution provisions: full ratchet and weighted average. Both aim to protect shareholders, but they operate differently and have distinct implications.
Full Ratchet Anti-Dilution
The full ratchet provision adjusts the conversion price of existing shares to match the lowest price at which new shares are issued.
For example, you own convertible preferred shares that can be converted into common shares at $10 per share. The company issues new shares at $5 per share. With a full ratchet provision, your conversion price is adjusted to $5 per share, allowing you to convert your preferred shares at this new lower price.
Pros:
- Provides maximum protection for existing investors.
- Ensures that early investors are not disadvantaged by future, lower-priced funding rounds.
Cons:
- Can be seen as too investor-friendly, potentially deterring new investors.
- Dilutes the ownership of non-protected shareholders significantly.
Weighted Average Anti-Dilution
The weighted average provision adjusts the conversion price based on the average price of existing shares and the new shares being issued. There are two types: broad-based and narrow-based.
For example, you own convertible preferred shares that can be converted into common shares at $10 per share. The company has 1,000 shares outstanding and issues 1,000 new shares at $5 per share. With a weighted average provision, your new conversion price is calculated based on the total value of old and new shares. See example below:
New Conversion Price =((O + N) * P) / (O + A)
Where:
O = Original number of shares
N = New shares issued
P = Original conversion price
A = Number of shares after issuance
Pros:
- Balances protection for existing investors with the need to attract new investors.
- Less dilutive to founders and early employees compared to full ratchet.
Cons:
- Provides less protection than full ratchet.
- Calculation can be complex and might require detailed record-keeping.
Conclusion
Anti-dilution clauses are essential in protecting shareholders from the effects of dilution during new share issuances. Understanding the differences between full ratchet and weighted average provisions is crucial for both investors and companies. While full ratchet offers maximum protection, it can deter new investors and significantly dilute non-protected shareholders. On the other hand, the weighted average provides a balanced approach, safeguarding existing investors while remaining attractive to new ones. Careful consideration of these provisions can help maintain a fair and equitable shareholding structure as the company grows.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.