CVC 11: How anti-dilution protection works
Anti-dilution protection is a crucial provision in venture capital agreements designed to protect investors from the dilution of their ownership stake e.g. when a company undergoes a down round in future #fundraising. For Corporate Venture Capitalist those downside protection can be particularly critical - for example in an event of setting the valuation by leading / co-leading a round or participating in a round where you feel not comfortable with valuation.
In volatile market environments like today (particularly uncertainty e.g. in future interest rate development) #anti-dilution protection clauses are essential provisions. There are two primary forms of anti-dilution protection (1) full ratchet and (2) weighted average, which have distinct characteristics and implications for both investors and the company:
(1) Full Ratchet:
Mechanism: Full ratchet is a straightforward and stringent form of anti-dilution protection. In the event of a down round, the conversion price of the investor's existing preferred shares is fully adjusted to the price of the new shares issued in the subsequent round. It is essential a "do-over" clause. In several jurisdictions, I have seen “bonus” shares (at nominal value without a premium) issued to the investor with full ratchet right till the point they are fully compensated.
Effect: This means that the existing investor's shares are protected at the exact price of the new, lower valuation round. In essence, the investor is fully insulated from any decrease in the company's valuation, as their shares are converted as if they had been issued at the new, lower price per share. Full ratchet provides robust protection for investors, however few things need to be taken into account (i) shareholding (exercising full ratchet might increase shareholding level), (ii) tax implications depending on jurisdiction, (iii) founders shareholding implication / dilution and (iv) relationship and different incentive levels between investors with and without full-ratchet protection.
(2) Weighted Average:
Mechanism: Weighted average anti-dilution protection is a more nuanced approach and I have seen this more commonly used. It calculates an adjusted conversion price based on both the price and the number of shares issued in the subsequent round. There are two variations of the weighted average formula, broad-based and narrow-based.
a) Broad-Based: This includes all outstanding shares (existing and new) in the calculation, providing more protection for the investor. The formula is designed to dilute the existing shareholders less than the full ratchet approach.(Common outstanding previously issued + common issuable for the amount raised at the prior conversion price) ÷ (Common outstanding previously issued + common issued in the new deal).
b) Narrow-Based: This only considers the number of outstanding common shares (excluding options and convertible securities) in the calculation. Narrow-based is generally more favorable to the company and existing shareholders.
Effect: Weighted average anti-dilution protection is a more moderate approach. It considers both the price and the number of shares issued in the subsequent round to calculate the adjusted conversion price. This method takes into account the overall impact of the new financing on the investor's ownership stake. In case of a down round, the investor with weighted average protection is partly protected from lower valuation. The protection is not completely protected as it would be under full-ratchet protection (“do-over”).
Conclusion: Anti-dilution provisions play a crucial role in venture capital investments, safeguarding investors' interests and ensuring their ownership stakes are protected against potential dilution. The choice between (1) full-ratchet and 2a) broad-based weighted average or 2b) narrow-based weighted average depends on many factors such as current cap-table, valuation, negotiation power founder/ new investor, etc. By understanding the different types of anti-dilution provisions and their implications, both investors and entrepreneurs can negotiate investment terms that strike a balance between protecting investors and preserving value for all shareholders.
Disclaimer: The views and opinions expressed in this post and under my Corporate Venture Capital newsletter are solely mine as the author and do not necessarily reflect the official policy, position, or opinion of my employer. Any content provided are my personal views and not investment advice.