Anti-dilution rights help the investors in protecting their ownership of the company. These provisions are built on convertible preferred stocks and some other options to provide a shield to the investors from potentially losing the value of their investment. This provision is especially significant in venture capital investing, as many rounds of financing are used. To understand this further, let us illustrate this via an example – a company XYZ has 1000 outstanding shares out of which A holds 250 shares. This means he owns 25% of the company’s stake. Now if XYZ wants a second round of financing, it further issues 1000 shares for subscription for the new investors. This will reduce A’s share from 25% to 12.5%. This is where the anti-dilution clause comes to rescue the existing investors. The anti-dilution protection is given only when the share price is lesser than the price paid in the previous financing round, the preferred shareholder gets more share of common stocks when he/she converts.
BENEFITS OF ANTI-DILUTION
- Protects the investor equity – Every investor hopes for an increase in the value of his portfolio. However, the market conditions may result in significant losses or valuation swings in different market cycles. An Anti-dilution clause provides the investor protection and is usually considered an automatic right. It protects the investors from market insecurities even when the firm borrows more funds at a reduced cost, it will safeguard the initial investors.
- Protects the company– this clause always encourages and motivates the company to seek higher valuations at all times and incentivizes it to perform better towards this end. Hence increase in performance and capital expansion go hand in hand.
TYPES OF ANTI-DILUTION PROVISIONS-
In India, two forms of anti-dilution protection are commonly used – (a) Full Ratchet and (b) Broad-Based Weighted Average
- Full Ratchet – under this method if the price of the shares issued in the subsequent round of investment is lower than the price per share paid by the existing investor then the conversion price will be revised to the price at which the new shares are being issued. With a full ratchet provision, the conversion price is adjusted downward to the price at which the new shares are issued in later rounds. For example: if the original conversion price is Rs. 100 and in later round the conversion price is Rs. 50, then for the investor, the original conversion price will be adjusted to Rs. 50. Here the conversion ratio is 1:2 and the investor will be issued additional shares without paying any extra consideration. In other words, it will be assumed that the investor had originally invested in the downward price and its shareholding will be adjusted accordingly. The full-ratchet method does not take into account the existing number of shares held by the investor, instead only the price at which the new shares are being issued and the new price will be applied to all the shares. Thus, the full ratchet method is harsh on the company whereas it’s favorable for the investors.
- Broad-Based Weighted Average – This is considered as a more balanced and fair mechanism, to which both investors and founders have consented to. Under this method, several factors are taken into consideration like valuation of the original investment, the number of shares proposed to be issued, the purchase consideration to be received by the company with respect to such issuance. The Adjusted Conversion Price is derived from the following formula – CP2 = CP1 x (A+B)/(A+C)
Where CP2 – new conversion price
CP1- conversion price before the down round
A- Fully diluted capitalization of the company before the down round
B- total consideration received by the company for the new issue divided by C1
C- number of new shares issued
To further illustrate this via an example let us look at this table-
|Shareholder||No. of shares||Ownership percentage|
Investor A bought the 1,00,000 shares at Rs. 2 per share. Now in the next round of investment, investor B wants to 5,00,000 but at a lower price of Rs. 1 per share. In order to protect Investor A from his ownership dilution the following formula will be used. CP = Rs. 2 per share
B = 2,50,000
C = 5,00,000
CP2 = 2*(10,00,000 + 2,50,000) + (10,00,000 + 5,00,000)
Now the owners of the first issue would be given the option to convert their shares at Rs. 1.67 rather than Rs. 2
Therefore, this method takes into consideration the number of shares issued in a subsequent round of investment and the number of shares held by the existing investors.
It is significant for both founders and investors to understand the metrics, formula, and true impact of this clause before contractually agreeing to it. Due to the onset of the Covid-19 pandemic in the country, there is a dip in company valuations, and with companies raising money at lower valuations, discussions, and enforceability of these clauses spring into action.