Venture deals in IT: anti-dilution protection

We continue to look at the tools that are most often used in VC deals. Our main goal today is to tell you about such a complicated mechanism as anti-dilution protection. Well, let’s get into it 😊

What is anti-dilution protection?

Anti-dilution protection is a mechanism that allows the investor to protect his shares from dilution, i.e. to keep the size of his share as much as possible in case of a down round (attracting new investments into the company at a price per share lower that is less than price per share when the investor made the financing). 

Let’s take an example: the investor financed 200 000 USD into your startup, and received 20 shares (i.e. 10 000 USD per share). A second round of funding takes place, and for some reason it is at a lower price than the first one: IP development and product launch were not completed, the company did not fulfill the set sales plan, the investment climate in the moment is generally not very promising, etc. Thus, a new investor is ready to invest 100 000 USD for 50 shares (i.e. 2 000 USD per share). In this case, the share of the first investor is diluted, and the first investor loses what he originally claimed when entering the company.

Anti-dilution protects the interests of the first investor in such a situation.

Implementation of anti-dilution

Traditionally, this mechanism is implemented by increasing the number of shares of the first investor (without additional payment): preferred shares of the investor are converted into a larger number of common shares. In some jurisdictions, another option is also possible: additional amount of preferred shares can be issued to the first investor (at par nominal fee). The final number of convertible shares of the investor in any of the options depends on the type of conversion agreed upon by the parties at the negotiation stage (see below).

Note that the investor does not necessarily exercise its anti-dilution rights immediately when the second investor enters the company. Most likely, anti-dilution will be realized by the first investor later, for example, during the exit (investor’s exit from the startup).

Types of anti-dilution protection 

There are two main types of anti-dilution protection: full-rachet basis and weighted-averaged basis:

1. With anti-dilution on a full-rachet basis, the conversion price per share is equal to the price per share on a down round. Let’s look at the example we gave above: the first investor bought 20 shares in the company for 10 000 USD each (total 200 000USD), the new investor bought 50 shares for 2 000 USD each. To calculate the number of shares of the first investor after conversion (i.e. when the anti-dilution mechanism is applied), we need to divide the amount of his investment (200 000 USD) by the price of one share at down round (2 000 USD). Thus, we get the number of shares that the first investor should get after conversion – 100 shares.This type of anti-dilution is rather strict and favorable only for the first investor, as it significantly dilutes the other members of the company (founders).
2. Anti-dilution on a weighted average basis: the conversion price is calculated as a weighted average between the price per share at the moment of entrance into the company of the first investor and the price per share at the down round. Calculation is made according to the formula: CP2 = CP1 * (A+B) / (A+C), where:

• CP2 = New Conversion Price (new conversion price of shares for the first investor)
• CP1 = Old Conversion Price (old conversion price for the first investor)
• A = Number of shares before the new round
• B = New Investment Amount / CP1 (how many shares the new investor would receive if he had entered at the old price)
• C = how many new shares were issued at the down round to the new investor

Anti-dilution formula on a weighted average basis is divided into two sub-formulas, which are distinguished by “A” indicator (number of shares to be taken into account) from the formula above: 

• narrow-based weighted average: only the investor’s preferred shares are taken into account in the calculation,
• broad-based weighted average: the calculation takes into account all the shares of the company: investor’s preferred shares, common shares of founders, shares reserved for options and ESOPs, convertible loans, etc.

In simple words: the conversion is a weighted average between the price of the first round and the new round. This type of anti-dilution protection is more favorable for founders, it is more balanced and in the interest of both parties to the transaction.

Anti-dilution protection is an important instrument, to which the founder should pay due attention: determine what type of anti-dilution the investor is offering, understand the conversion formula, and understand how reasonable this or that option is in your deal. Full rachet is the most disadvantageous option for the, so if you see it in the documents, do not be afraid to enter into negotiations with the investor and offer softer types of anti-dilution.