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Understanding Anti-Dilution Provisions

Anti-dilution provisions refer to specific rights attached to preferred stock, intended to be issued to investors. The provisions ensure that an investor’s stake in the company is not diluted by an influx of subsequent stocks issued at a price below the original purchase price (i.e. as part of subsequent round of financing in a down round situation).

Anti-dilution provisions allow investors to essentially obtain more shares, adjust share prices for conversion, through two main mechanisms:

1. Weighted Average. This is a fairly complex formula that essentially gives an investor more shares down the line, at no extra cost, to compensate for a down round. In a nutshell, the formula takes into consideration how much money was invested as part of the down round, and based on that allows for a partial price adjustment. It has generally been the industry standard for anti-dilution provisions, especially in an economy where lots of financing is going on.

2. Full Ratchet. This anti-dilution provision allows for a full correction of the price paid. Which means that if an investor bought a share at a price of $10 per share and in a down round, the price is determined to be $5, and such investor will be entitled to receive more shares as if she originally invested at a price of $5. As evident, thus is a much stronger protection for the investors and its less favorable to the founders for obvious reasons of dilution.

Here are a few additional resources that help unpack the idea of anti-dilution provisions:

Anti-Dilution Provisions in VC Transactions Weighted Average (Broad/Narrow Based) & Full-Ratchet
Understanding How Dilution Affects You At A Startup

This blog does not provide legal advice and does not create an attorney-client relationship. If you require legal advice, please contact an attorney directly.