Anti-dilution Provisions

Before committing to an investment, startup investors typically require companies to provide special accommodations not given to common stockholders. Anti-dilution provisions are some of the most important protections that startup investors receive and often play a central role in term sheet negotiations between investors and founders. Anti-dilution provisions protect investors by preventing them from experiencing large amounts of dilution in future financing rounds, but they can also have a detrimental impact on the stake of founders and employees.

This article explains the purpose of anti-dilution provisions, describes their many variations, and provides an example that illustrates how they can affect your equity position. (See our Dilution and Stock Option Pools and Term Sheets Overview articles for more information about these topics.)

Overview of Anti-dilution Provisions

Anti-dilution clauses protect preferred stockholders from losing large portions of their ownership percentage if a subsequent round of funding results in a lower valuation. Whenever a company issues additional equity, existing shareholders give up some of their ownership percentage in the company. As long as the company valuation continues to rise, investors usually accept the dilution because the value of their equity stake is still increasing. If the valuation for the company falls relative to the previous valuation in what is known as a down round, investors can suffer significant losses in ownership percentage and in the value of their investment.

Due to these concerns, investors insist on having anti-dilution provisions that shift much of the dilution from the preferred stockholders to common stockholders. Anti-dilution protections prevent preferred stockholders from experiencing dilution by adjusting the conversion ratio at which preferred stock will convert to common stock. Conversion ratios determine how many shares of common stock investors will receive in exchange for their preferred stock. A conversion ratio of 1 (or 1:1) means that preferred stockholders receive 1 share of common stock for 1 share of preferred stock. A conversion ratio of 2 (or 2:1) indicates that preferred shareholders will receive 2 shares of common stock for each share of preferred stock. Conversion ratios are calculated using the following formula:

Immediately following an investment, the conversion price for the preferred stock is usually set to the purchase price, resulting in a conversion ratio of 1 (or 1:1). Without an anti-dilution clause, this conversion ratio remains fixed at 1, except for any adjustments for stock splits.

Down rounds⁴ automatically trigger anti-dilution provisions and lower the conversion price for the preferred shareholders. Lowering the conversion price increases the conversion ratio, providing preferred stockholders with additional shares of common stock upon conversion. These additional shares help offset the dilutive effect of the down financing round. Meanwhile, common stockholders (including founders) do not have anti-dilution protections. The number of shares they own is fixed, regardless of the funding round’s valuation. The anti-dilution provision causes common stockholders to experience even more dilution than in a typical funding round.

Employee stock option plans and warrants issued to lenders usually do not trigger anti-dilution preferences. Some term sheets⁵ set a limit on how many shares can be issued in an employee option plan before anti-dilution provisions go into effect. You should be aware of the exact circumstances that will trigger anti-dilution provisions when creating stock option pools⁶. (For more information on stock option pools, see our Dilution and Stock Option Pools article.)

Types of Anti-dilution Provisions

Investors and management can agree to any number of different ways to compute the conversion price adjustment, but the two most common forms are full ratchet provisions and weighted average provisions. Sometimes late-stage investors use anti-dilution provisions called ratchets (different than a full ratchet) to guarantee a desired minimum return. Each of these variations is described in greater detail below.

Full Ratchet Provisions

These provisions set the conversion price equal to the lowest price at which stock has been subsequently issued. For example, a Series A investor who purchased an equity stake at $2.00 per share would initially have a conversion price of $2 and a conversion ratio of 1 ($2 / $2 = 1). Consider how the conversion ratio would change if the Series B investors purchased shares in a down round at $1 per share. The purchase price would stay at $2, the conversion price would drop to $1, and the conversion ratio would increase to 2 ($2 / $1 = 2). Upon conversion, the Series A investors would receive 2 shares of common stock for each share of preferred stock (instead of 1 share each) due to the conversion price adjustment.

Essentially, full ratchet provisions allow prior investors to obtain common equity at the same “price” as the subsequent investors. Even after the conversion price adjustment, however, investors will still own a smaller portion of the company on a percentage basis.

Full ratchets are the most investor-friendly clauses and result in the most dilution for founders. Before agreeing to a financing arrangement that includes a full ratchet provision, you should carefully consider the potential impact to your ownership stake in the event of a down round.  As with most other aspects of the term sheet, you can explore negotiation opportunities to amend the anti-dilution provisions included in the original term sheet.

Weighted Average Provisions

Unlike the full ratchet provisions described above, weighted average anti-dilution provisions do not completely lower the preferred shareholder’s conversion price to the price of the lowest subsequent funding round. Instead, these provisions lower the conversion price to a value in between the investor’s initial purchase price and the lowest subsequent funding round.

The weighted average method calculates the adjusted conversion price using both the pricing and size of the down round. Investors receive a higher conversion rate for more dilutive financing rounds (financing rounds with lower valuations and/or more capital being raised). If the down round would be more dilutive to investors, they receive a higher conversion ratio to offset this dilution. Weighted average anti-dilution adjustments are most commonly calculated using broad-based formulas or narrow-based formulas.

‍Broad-based formulas assume that all potentially dilutive securities (warrants, stock options, convertible debt, convertible preferred stock) convert into common stock. The following formula shows how the broad-based conversion price is often calculated:

Remember that the above formula determines the new conversion price, which will then be used to calculate the conversion ratio. The lower the conversion price, the higher the conversion ratio, resulting in more shares of common stock to investors with anti-dilution provisions.

In the formula, the (A+B)/(A+C) term serves as a percentage or a “weight” that decreases the conversion price (increasing the conversion ratio) as long as C > B (there is a down round). The scaling of the conversion ratio depends on how many shares are sold and at what price. Broad-based formulas are more common than narrow-based formulas and are preferable for founders because it results in smaller anti-dilution protections for investors.

‍Narrow-based formulas are very similar to broad-based formulas, only they exclude dilutive securities not yet reflected in common stock. These formulas are less preferable for founders because they provide preferred stock investors with more common stock upon conversion. The formula for calculating the conversion price using a narrow-based formula is often the same as the broad-based formula except that the A variable does not include any dilutive securities.

Ratchets

Whereas most anti-dilution provisions protect against the effect of future financing rounds, some startups provide protection against unfavorably low exits⁹ by linking the conversion ratio to the investor’s final return. In these arrangements, the startup agrees to increase the conversion ratio (and issue more common stock to investors) if the company’s exit does not meet the return specified in the ratchet provision. The company essentially guarantees a minimum level of return to the investors. These very generous ratchets are usually included in late-stage investment rounds when the startup expects a liquidity event¹⁰ in the next few years. If the exit price does not reach a certain level, the conversion ratio increases until the investors receive the guaranteed level of return.

You should be hesitant to agree to a ratchet that guarantees a return to investors upon a liquidity event. If your startup struggles to meet its goals or the capital markets change unfavorably, you may have to issue additional shares to investors, further diluting the value of your equity position. In 2014, the mobile payment startup Square raised $150 million in a Series E round. The agreement included a ratchet that guaranteed the Series E investors would receive a 20% return on the initial investment in an IPO. In November 2015, when Square went public, the ratchet provision forced Square to provide $93 million of additional shares to Series E investors. Other companies that have employed similar types of ratchets include AppDynamics, BuzzFeed, Box, and Nutanix.

The presence of ratchet “guarantees” can also lead to inflated valuations. A study by the law firm Fenwick & West LLP in 2015 discovered that 30% of venture-backed unicorns¹¹ had raised capital with investor-friendly ratchet provisions. Investors are willing to agree to higher valuations for deals that include ratchet provisions because they know that the company is guaranteeing the return. As a result, these valuations are likely higher than what public-company investors would pay for the company without such assurances. These provisions show that startup valuations are not necessarily comparable, even for similar companies. You cannot simply use a competitor’s valuation as a benchmark for your own valuation without considering the terms of the deal.

Example

Consider a hypothetical technology startup named Startup Incorporated that has just successfully raised $5 million from a Series A investor at $1 per share. For simplicity, assume that Startup Inc. has only one founder and one investor in each funding round. The cap table for Startup Inc. after the Series A round is shown below.

Two years later, Startup Inc.’s industry unexpectedly experiences a significant slowdown, forcing the company to raise capital. The company raises a $2 million Series B round that values the company at $0.50 per share. The two scenarios below will illustrate the effect that anti-dilution provisions would have on the founder’s ownership position under these circumstances.

Scenario 1: No Anti-dilution Provision

The following cap table shows the ownership structure of Startup Inc. after the Series B round if Series A investors do not receive any type of anti-dilution provision. Notice how the conversion ratios for both the Series A and Series B investors are set at 1. Without an anti-dilution provision, the conversion ratio remains at 1 even in subsequent funding rounds.

The down round valuation allows the Series B investor to secure a substantial equity position in the company but for half the cost of the Series A investor ($1 per share versus $0.50 per share). By virtue of the new equity issuance, all of the previous shareholders (Series A investor, founder, and employees) experience some dilution. Even worse, the recent valuation means that Startup Inc. is worth half as much as it appeared to be worth in the Series A round. Over two years, the Series A investor has achieved a -50% return.

The decline in ownership percentage and the decline in value highlight why investors insist on receiving -anti-dilution protection. The next scenario will demonstrate how anti-dilution provisions protect preferred shareholders at the expense of founders and employees.

Scenario 2: Full Ratchet

If the Series A investor had received a full ratchet, her conversion price would have lowered to $0.50 due to the Series B down round. The conversion ratio would have increased to 2, as calculated below:

Conversion Ratio = Original Purchase Price / Conversion Price = ($1 per share) / ($0.50 per share) = 2

Therefore, on an as-converted basis, the Series B investors would receive twice as many shares of stock when compared to the first scenario. The cap table for this scenario can be seen below.

Notice how the anti-dilution protection provides the Series A investor with twice as many common shares (10 million versus 5 million) due to the anti-dilution provision. This increase in common stock shows how anti-dilution provisions protect the stock of preferred shareholders. Not only did the Series A investor receive a higher ownership percentage in the second scenario, but the value of her stake has increased dramatically in the process. However, this increase in the number of common shares outstanding dilutes all of the other shareholders. The Series B investor only ends up receiving 16.7% of the company in the scenario with the full ratchet while she received 21.0% in the first scenario.

The founders and employees are the shareholders that are harmed most by the full ratchet. The founder who owned 60% of the company after the Series A round now only owns 37.4% of the company after the Series B round and the anti-dilution adjustment. The founder and company employees experience dilution for both the down round and the Series A anti-dilution adjustment. The 12.6% change in ownership percentage from the Series A round in Scenario 1 illustrates the dilutive effect of the down round, and the 10.0% change from Scenario 1 to Scenario 2 demonstrates the dilutive effect of the Series A anti-dilution provision.

Scenario 3: Weighted Average Provisions

The third scenario illustrates how the distribution of ownership in the company changes if the Series A investor had received a weighted average anti-dilution provision. This scenario demonstrates how to calculate conversion prices using both a broad-based and a narrow-based formula.

‍Broad-based Formula

A broad-based formula (like the one provided earlier in the article) considers any equity already issued by the company as well as any potentially dilutive securities. As a result, the broad-based formula not only considers the founder’s common stock and the Series A investor’s preferred stock, but also the stock option pool. Stock option pools represent options that have been set aside for employees, but those options may not have been granted, vested, and exercised¹². Since these shares could vest in the future and become equity, they must be included in the total amount of shares outstanding for broad-based formulas. (If Startup Inc. had convertible debt, warrants, or any other form of potentially-dilutive securities, these securities would also need to be included in the broad-based calculation.) Using the broad-based formula presented earlier in the article, the Series A conversion price would be calculated to be $0.895 (rounded) as shown below:

A conversion price of less than $1 means that the Series A investor will be able to receive common stock (when the preferred stock converts) at a cheaper rate than its original preferred stock purchase. Said differently, the investor will receive more shares of common stock than it had in preferred stock (the lower conversion price leads to a conversion ratio above 1). When the Series A investor converts its holdings to common stock, it will receive 1.118 (rounded) shares of common stock for each share of preferred stock. The calculation of the conversion ratio is shown below:

The cap table for this scenario can be seen below:

Notice that in this scenario, the Series A investor receives more common shares (5.59 million) on an as-converted basis than in Scenario 1 (no anti-dilution provision - 5 million) but not as many shares as in Scenario 2 (full ratchet - 10 million). As a result, the weighted average anti-dilution provision is less dilutive to all of the other shareholders (including the incoming Series B investor). As demonstrated by this scenario, weighted average provisions usually provide some anti-dilution protection to investors without having an excessively dilutive impact on other stakeholders. Because these provisions represent a compromise between the interests of founders and investors, weighted average provisions are the most common type of anti-dilution provision.

‍Narrow-based Formula

‍The key differentiating factor between a narrow-based formula and a broad-based formula is how the formulas determine the number of shares currently outstanding. A narrow-based formula only considers equity shares that have already been issued and does not consider any potentially dilutive securities (like stock options, convertible debt, or warrants). Startup Inc.’s stock option pool would therefore be excluded from the narrow-based formula and the number of shares outstanding would only consider the founder’s common stock and the Series A investor’s preferred stock. Using the narrow-based formula presented earlier in the article, the Series A conversion price would be calculated to be $0.895 (rounded) as shown below:

The calculation of the conversion ratio for the narrow-based provision is shown below:

Based on the mechanics of the formula, the narrow-based formula would result in a slightly lower conversion price ($0.889) when compared to the broad-based formula ($0.895). As a result, the narrow-based conversion ratio (1.125) is slightly higher than that of the broad-based conversion ratio (1.118). As a result, under the narrow-based formula, the Series A investor would receive 5.625 million shares (35,000 more shares than the broad-based formula), equivalent to 28.7% ownership of the company.

Like the broad-based formula, the narrow-based formula results in an anti-dilution protection to the Series A investor that is less than the full ratchet but more than having no anti-dilution provision at all. Because Startup Inc.’s fact pattern gives such similar answers for the narrow-based formula and the broad-based formula, a cap table was not created for the narrow-based formula.

Because the amount of potentially dilutive securities (1 million shares in stock option pool) was a relatively small part of the overall capital structure, the narrow-based and broad-based formulas provided very similar results. For a company in which potentially dilutive securities are a much larger portion of the capital structure, the results from the narrow-based and broad-based formulas could diverge significantly.

There are a few other considerations related to the weighted average calculations that you should keep in mind. First, the number of additional shares that investors receive in a broad-based or a narrow-based formula depends significantly on the size and valuation of a company’s funding rounds. Each startup’s history of funding will influence the amount of anti-dilution protection afforded to investors. Second, investors and founders have considerable flexibility in determining the weighted average formula included in the term sheet. Although the formulas provided in this paper are common formulas seen in many term sheets, entities could decide to use different formulas, which may produce very different results than those illustrated in the example above.

Conclusion

Anti-dilution provisions provide investors with downside protection in case future financing rounds occur at low valuations. Although these protections are clearly desirable for investors, you must carefully consider the potential for anti-dilution provisions to dilute your personal stake. Carefully considering the anti-dilution provisions within a term sheet will help you structure a deal that protects your best interests as well as those of your investors.

Resources Consulted

• Term Sheets & Valuations by Alex Wilmerding
• Brad Feld Blog: Term Sheet – Anti-Dilution
• DLA Piper : What Are the Price-based Anti-dilution Formulas?
• VentureBeat: Further demystifying the VC term sheet
• Fenwick & West: The Effect of Companies’ Late Stage Venture Financings on Their IPOs 2014 - 2015
• WSJ: Startups Ratchet Up the Risk With Share Promises
• WSJ: Square Pays $93 Million Penalty to Some Investors in IPO
• Forbes: Unicorn Square's IPO Triggers Terrifying Talk of Ratchets
• TechCrunch: Square’s S-1: Of Ratchets And Unicorn Valuations