Anti-dilution Protection for Founders

This article will talk about anti-dilution protection, a type of security grant to protect your founders’ equity ownership position.

As the startup founders, you might have plenty of time to worry about your company’s future. The investors give protection for their equity ownership positions becoming diluted or less valuable. This article will talk about anti-dilution protection, a type of security grant to protect your founders’ equity ownership position.

Anti-dilution protection and founders

There are several formulas used by the courts to determine the ownership percentage of the founder in a company that is taken public. In other words, anti-dilution protection is the right of an investor to have the same percentage ownership after a down-round in the financing. Read on for details about anti-dilution provisions.

What is anti-dilution provision or protection?

The anti-dilution protection is, in financial terms, a provision that is built into a convertible note or option to protect the investors’ ownership stake from dilution. In standard form, anti-dilution protection can be defined as a security grant that grants investors the same percentage ownership after down-round financing. It is the right of an investor to have a certain percentage of ownership that protects their ownership position.

How does anti-dilution provision work in the business?

Generally, the “anti-dilution provision” is just a part of the standard form when a security offering is made. But in cases where there are significant changes in the company’s valuation and amount of funding, or founders are trying to raise more money as they grow, anti-dilution protection becomes an essential part of the standard form. It can be stated that anti-dilution protection is an important right that may benefit investors.

Types of anti-dilution protection

Anti-dilution protection can be classified into different types under the reason of occurrence. Here are some types of anti-dilution provisions:

Full ratchet

This is a kind of anti-dilution protection with the unlimited enhancement of shares. It will be based on the full ratchet formula, which is a mathematical formula that takes into account features of future equity growth. It is harsh for business owners, but investors enjoy this protection.

Number of common shares = (Number of preferred shares) x (Original share price/Conversion Price)

Example: Assume that if the company makes a decrease in share price, if the original price was $10 and later the conversion price is $5, the investor’s original conversion price would adjust to $5.

Weighted average

This is anti-dilution protection that is based on the stock price-weighted average. New investors will get the same price when the company issues new shares. However, old investors’ shares will be adjusted according to new investors’ shares; in this case, the adjustment is made by using the formula given below:

Issued price per share x ((Number of shares outstanding + amount received at a prior price)÷ number of new shares) ÷ (Number of shares outstanding + number of new shares)

For example:

  • Issued price per share = $1
  • Number of shares outstanding = 12M
  • Amount received at a prior price = $10M
  • Number of new shares = 12M

Therefore, $1.00 x (12M + $10M/$1.00) / (12M + 12M) = $0.92

Here are two ways to calculate the weighted average anti-dilution: broad-based and narrow-based. The formulas are identical apart from the number of shares outstanding. For a broad weighted average anti-dilution protection, the number of shares outstanding includes all types of shares issued, including outstanding warrants and options. The narrow basis only considers the total number of preferred shares outstanding and excludes options, warrants.

Importance of anti-dilution protection

As we can see, some of the anti-dilution protection formulas affect the investors; now, let’s see the importance of anti-dilution protection in particular.

Importance of anti-dilution protection

  • It helps to avoid down-rounds – When the company is subjected to a down-round, and the investor receives new shares in exchange for old shares, some investors may be at risk of receiving fewer shares than before. However, anti-dilution protection can solve the problem that results from a down-round by preventing unnecessary dilution.
  • It is beneficial for employee compensation – Some of the employees who are granted stock options risk losing their value during a down-round. However, with anti-dilution protection, employees should not be affected by stock price decreases. This can benefit employees by reducing their risks when they exercise the options and buy shares at a cheaper rate.
  • It is useful in raising money – When a company needs to raise more money than before, it can be easier to gain investors’ trust with anti-dilution protection. Because of that, the company will not have to worry about the decrease of ownership since these investors are provided with protection.
  • It gives flexibility for both parties – There is an advantage that the investor and the company have because of anti-dilution protection. Because it is protected, the company can provide employees with certain advantages after business conditions change.
  • It is useful for early investors – Anti-dilution protection for early investors makes them happy as well. This is because they do not have to worry about the company becoming public or undergoing a significant change in ownership structure. And also, when other equity holders are getting new shares in exchange for their old ones, these new shares will not affect them too.

Anti-dilution adjustment clause

The anti-dilution adjustment clause is a measure to protect the existing investors when a company needs to issue new shares for financing. The anti-dilution clause can be found in the agreement or note, and it defines the conversion price of new shares issued during an equity financing that occurs after the note was issued.

Understand the Anti-dilution agreement for the founder

This is a founder’s anti-dilution agreement between founders and investors to protect investors against loss of value. This clause is normally used in standard form. The anti-dilution adjustment clause we are talking about here is about the conversion price of issued shares at a new funding round. The founder will provide investors with the anti-dilution adjustment document that contains information on the new funding round.

The conversion price will be calculated when new shares are issued. The anti-dilution adjustment is not a mechanism that favors the founders. The protagonist of this clause is the investor, as they want to protect their interests and prevent dilution. The anti-dilution agreement often plays a significant role in calculating the conversion price at a new funding round as it can be adjusted following a down-round.

Benefits of having anti-dilution clauses in the agreement

The anti-dilution agreement is a contract that investors and companies apply to adjust the conversion price of new shares to be issued. This is essential in that it allows companies to continue with their business while protecting the investor’s interest. Following are a few benefits of having clauses in the agreement:

  • Protection – As mentioned above, the anti-dilution adjustment clause protects shareholder interests by ensuring that the company does not excessively dilute them by either issuing new shares or issuing cash when the company has enough.
  • Price is fair – In this contract, both parties will agree on the price of their new shares to avoid any disagreements on conversion price. If there are disagreements on conversion price, then this is where the anti-dilution agreement comes into play and ensures that the price remains fair.
  • Adjustment of conversion price – Along with increasing the company’s stock price, this agreement will also allow companies to adjust their conversion prices and avoid any losses in the future.
  • Enforceable – This contract is pretty simple in that it makes it easy for both parties to comply with its terms. It also makes it easier for investors to have a chance at recovering their investments if the company starts issuing new shares without informing them.
  • Flexibility – Depending on each country’s laws, the anti-dilution agreement has its flexibility. It can often be adjusted according to an investor’s wishes to protect their interests and preferences.

Clauses included in the anti-dilution agreement

The clauses in an anti-dilution agreement can be seen in the note and the term sheet. The notable clauses are noted here as followings:

Clauses included in the anti-dilution agreement

  • Definition – The anti-dilution agreement is most commonly used in the note. The definition of the anti-dilution agreement will be given in this clause. In this term, “Conversion Price” means a price per share calculated by dividing par value into the aggregate consideration received by the company and deemed to be issued due to a capital transaction for common stock.
  • Anti-dilution payment – As mentioned above, the anti-dilution adjustment usually works in a company’s favor because they protect investors from dilution. However, if the company conducts a down-round conversion price of new shares will be adjusted downward, shareholders who purchased their shares before this round will have to pay the new issuers a certain amount.
  • Stock Options Exercisable in Connection with Qualified IPO – This clause means that if an individual becomes a director or executive officer in a qualified IPO, these stock options will be vested within one year of eligibility.
  • Withholding – The anti-dilution agreement also obligates investors to issue shares for directors and executives of the company. When a director, executive officer, or service provider gains access to a funding round to raise capital, investors will have an obligation to withhold some shares to ensure that the person is not diluting the interests of other stakeholders.
  • Non-Assignability – Companies usually like this clause as it gives them freedom on certain things. The investors have the right and the ability to sell assets while they won’t be able to make any changes in their shares and so on.
  • Notice of Record Date – The note or the term sheet will clearly state a date where you can record your shares within the company. As long as there are no retroactive changes, they can use this date to change the anti-dilution agreement and determine the conversion price later.
  • Miscellaneous – Some other miscellaneous clauses usually exist in this agreement. There are also some clauses such as the company’s obligation to use its best efforts to list on a public exchange, its obligation to use its best efforts to list on a public exchange, and similar clauses.

What is the need for having an anti-dilution agreement?

The need for having an anti-dilution agreement is actually very essential. It is essential to have this agreement in an industry like private equity because it will help both parties protect the company’s interests and maximize their profits. This will also help the company in changing or adjusting its stock price if needed. It is a legal framework that will help both parties avoid and address any future conflicts or disagreements.

Things to consider while negotiating anti-dilution protection

The anti-dilution protection is mostly negotiated during the company’s capital-raising process. There are a few details that you need to consider while negotiating this contract, such as:

  • Refrain from false negotiation – Both parties must be open and clear about all the clauses in their contract to help the company avoid any future conflicts and disagreements.
  • Communicate with your investors – You want to be clear about what you want in this anti-dilution agreement. This will also help save time and resources.
  • Include the clauses – while negotiating this clause, it is important to include all of the other possible clauses that may be included in the contract, such as the right to own shares through a fundraising round and so on.
  • Know your numbers – you must know the exact conversion price of your company. This will help you determine your company’s value and keep a track record of all the changes that you need to make in the future.
  • Skills and capital – While negotiating this agreement, it is important that you and your investors have certain skills and capital that will help you with your business. Having these factors will also ensure that you are headed in the right direction and protect your investors’ interests.

Why is choosing Eqvista an excellent idea for your business?

Anti-dilution protection is a contract that will protect both the investor and the company. It helps keep investors protected while ensuring that they do not lose their investments if their conversion price is changed. Therefore, you must think carefully about this agreement to help you in the future. Get in touch with Eqvista now. With our team of experts, we will surely help you streamline the process and bring you the best results.

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