During any fundraising process, a central part of the negotiations involve the provisions that protect investors from dilution in subsequent financing rounds.
Here, we'll dig into the different types of anti-dilution provisions you might find during fundraising conversations, the impact they can have on companies' cap tables, and how they can affect shareholder groups like founders and employees.
What are anti-dilution provisions?
In a startup, the parties benefiting from anti-dilution protections are usually investors. Because investors are committing capital to an early-stage, high-risk business idea, they often seek to hedge their bets with anti-dilution provisions, in case their investment declines in value.
As companies grow, the number of people or entities who own bits of the company grows too. This is especially true for fast-growing tech companies, who may need to raise investment to keep scaling and who often award share options to employees and/or advisors.
At the start of a company's journey, ownership is usually divided between the founders. Then, angel investors may come on board, followed by the first institutional investors at the seed or Series A round. And at some point along the way, the founders should decide on the size of the employee stock option pool too.
So when does dilution start to matter? To answer the question we need to think about stakes and pies. 🥩 🥧
The value of someone's ownership is determined by the number of shares they own, multiplied by the share price. Let's use a very simple example. If a business has 100,000 shares, and each share is worth €10, the business is worth €1 million. A seed investor owning 10,000 of those shares owns 10% of the business, and those shares have a value of €100,000.
Now, if the business is performing well and growing quickly, new investors may be interested in owning a piece of the company. So the company raises money from investors in a funding round. The investors and founders agree that because of the company's growth and future potential, the valuation should increase. This change in valuation usually happens by the company issuing more shares, or by the price per share increasing.
Let’s say the new funding round is a Series A. The Series A investors acquire 20% of the business, diluting earlier investors and shareholders. Our diluted investor who previously owned 10% of the business now owns 8% – dilution has reduced their stake by 20%.
But the new investors agree to increase the price per share to €20, effectively doubling the valuation of the business to €2 million. (For simplicity's sake we won't worry about issued shares and outstanding shares here.)
Our seed investor's stake has been diluted down to 8%, but the value of their stake has increased: owning 8% of a business worth €2 million means their stake is now worth €160,000.
(This infographic created by veteran investor Mark Suster is a nice way to think about the size of the stake getting smaller while the size of the pie gets bigger.)
Why are anti-dilution provisions important?
Ideally, in an investment round the valuation of the company will increase. This softens the blow of an investor's percentage ownership stake being reduced. As long as the valuation of the company rises, investors usually don’t mind the decrease in ownership, because the increase in valuation raises the post-money value of the stock they’re holding.
But the calculations change if a fundraising process results in a down round – the term for a funding round that gives a company a lower valuation than the previous round. If a down round occurs, investors would need to mark a paper loss on their investment and – if the company sells or exits at that lower valuation – crystallise a loss on their balance sheet.
Another reason why dilution matters to investors is to do with the voting power and control of the company. In most cases, control and voting power are tied to the amount and type of shares held by a given shareholder. Investors and even founders can find themselves outnumbered if their ownership in the company is diluted beyond a certain point.
For instance, in both Switzerland and the UK, anyone controlling 25% or more of a company is known as a beneficial owner. There are stricter information disclosure requirements placed on beneficial owners compared to other shareholders who own less of the business.
Types of anti-dilution provisions
Usually, in a financing round, investors buy so-called preferred stock. Preferred stock is great for investors because preferred shareholders get their money back first in the event of an exit, above common stockholders.
In certain cases, the investor can choose not to use this right, instead converting their preferred stock to common stock. Here's where it gets interesting. Normally, the conversion price equals the price per share of the common stock from the round. For example, if an investor committed €1 million and the price of each common share is €1, the investor would receive 1 million shares.
However, if the company valuation decreases and a down round is on the cards, anti-dilution provisions allow this ratio to change. Usually, this means lowering the price at which investors’ preferred stock converts into common stock. This effectively increases the amount of common stock investors are entitled to receive in the event of an exit.
Converting preferred stock to common stock can be an inflammatory issue for companies and investors. In May 2023, it was reported that Revolut investor SoftBank was seeking additional compensation in exchange for converting its preferred stock into common stock, after the Bank of England raised concerns about the number of different share classes on Revolut's cap table.
The most common types of anti-dilution are full ratchet and weighted average (which can be broad or narrow – but we'll get to that). Full ratchet anti dilution is generally better for investors while weighted average is more founder-friendly.
In the case of a full ratchet anti-dilution, investors get to retain almost the same percentage of your company as before the down-round. For that to be possible, the conversion price for the investors’ preferred shares has to be adjusted.
For example, if Series A investors paid €2 per share but a down round means Series B investors pay €1, the earlier investors would stand to lose 50% of their investment. However, if a full ratchet provision is in place, Series A investors have the right to convert their shares at the new, lower price of €1. This means that each preferred share the Series A investor holds now converts to two common shares, instead of only one.
Even though many investors seek down-round protection, full ratchet isn’t very common in practice, and is only beneficial for the investor.
Weighted average anti-dilution protection works a little differently to a full ratchet. It doesn't claw back everything in the event of a down round: instead, it softens the blow for investors without fully compensating every penny lost.
We saw previously that with a full ratchet anti-dilution protection, the conversion price simply equals the price agreed in the new down round funding. Using a weighted average provision, a new price per share is agreed to compensate earlier investors that's between the previous higher price and the new lower price agreed in the down round. In our example above, we'd get a price somewhere between €2 and €1. If €1.50 is agreed as a compromise, each preferred share would turn into 1.5 common shares.
But of course, it's not quite that simple. There are two types of weighted average: broad-based, and narrow-based.
Broad-based weighted averages include a wider range of stock when calculating a conversion price. This includes all fully diluted and outstanding common stock. In contrast, a narrow-based weighted average doesn't include fully diluted share capital in its calculations. Therefore, for instance, employee share options would be included in a broad-based weighted average but excluded from a narrow-based calculation.
Generally speaking, the narrow-based formula works in favour of the holders of preferred stock (i.e., investors) and usually dilutes existing common stockholders to a greater extent.
Anti-dilution: what should founders and leaders do?
For founders building high-growth companies and seeking capital from investors, some dilution is inevitable as the company grows. But with more down rounds potentially on the horizon for companies, anti-dilution preferences could start to really impact the cap table.
Of course, the best option for founders is to have no anti-dilution protections written into term sheets and contracts. However, if anti-dilution clauses are a reality, we recommend adopting weighted average provisions over a full ratchet, as this will partially compensate earlier investors while preventing excessive dilution of common stock holders.
How do I model the impact of an anti-dilution provision in my cap table?
Equity management software like Ledgy allows you to model different scenarios and factor in the impact on shareholders when dilution occurs. For instance, the below image demonstrates a scenario that shows the effect of a funding round on preferred shareholders and common shareholders. Explore Ledgy's scenario modeling in more depth.
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