In a situation where you invest directly into a company and the company later on issues new shares at a price that is lower per share than the price you paid, the consequence could be that you are diluted both as regards your economic rights and as regards your control rights in the company.
To protect against this, the seasoned investor will often request an anti-dilution clause as part of the investment agreement – especially in times when valuations are uncertain. Conversely, offering anti-dilution protection may be a way for the company to give an investor sufficient comfort to actually pull the (investment) trigger.
The design of these protection clauses may have significant consequences in the event of a subsequent down-round for all shareholders, and it is therefore key to understand if, and if so what type of, anti-dilution protection should be requested – or, depending on your position – accepted.
Here is a 101 of the 2 most common types of anti-dilution clauses in investment agreements.
The initial investor (who is granted anti-dilution rights) will in the following be referred to as Investor 1, and any following investor that participates in a subsequent investment round will be referred to as Investor 2. To make the example as straightforward as possible, Investor 1 will not invest in the subsequent round.
The mechanism
The typical anti-dilution mechanism will function so that if a so called down-round occurs, Investor 1 will be entitled to receive additional shares for free (or at par value if required) in order for Investor 1 to be compensated for having paid (what turned out to be) a too high price for its shares.
Anti-dilution clauses can of course come in various forms, and below is a general introduction with two of the most common alternatives.
Alternative 1 – Full-ratchet anti-dilution
This model will be most beneficial to Investor 1. If a down-round occurs, Investor 1 will be entitled to compensation shares as if he had invested at the same price per share as in the down-round. In an extreme scenario, that means that if as much as a single share is issued at a lower price per share, Investor 1 could still be entitled to a significant number of new shares despite having suffered practically no dilution (which is the fundamental reason for having the mechanism in the first place).
The fundamental feature of the full-ratchet model is just that, i.e. that it disregards the number of shares issued in the down-round. As will be shown below, a full-ratchet model can hence serve to significantly increase Investor 1’s shareholding in the company.
Example 1
Investor 1: Invests 10 MSEK
Price-per-share: 10 SEK
Post-money valuation: 100 MSEK
Investor 1’s stake: 10 %
1(a) Down-round occurs:
Investor 2: Invests 25 MSEK
Price-per-share: 2.50 SEK
Post-money valuation: 50 MSEK
Investor 2’s stake: 50 %
Result: Investor 1 will then be diluted, and now holds 5 % of the company (pre anti-dilution protection). Investor 1 with full-ratchet anti-dilution gets an additional number of shares as if it invested at the same valuation (as if it acquired its shares for 2.50 SEK instead of 10 SEK each), and hence Investor 1 will increase its ownership to 17.4 % of the company.
1(b) Down-round occurs:
Investor 2: Invests 1 MSEK
Price-per-share: 0.90 SEK
Post-money valuation: 10 MSEK
Investor 2’s stake: 10 %
Result: Investor 1 will then be diluted, and now holds 9 % of the company (pre anti-dilution protection). Investor 1 with full-ratchet anti-dilution gets an additional number of shares as if it invested at the same valuation (as if it acquired its shares for 0.90 SEK instead of 10 SEK each), and hence Investor 1 will increase its ownership to 52 % of the company.
Alternative 2 – Volume weighted average (broad based)*
Volume weighted anti-dilution basically means that the number of compensation shares will relate to the size of the dilutive effect that the down-round would have.
A generally accepted formula* for calculating will typically be applied in this regard, that takes the de facto dilutive effect into account when deciding how many additional shares Investor 1 will receive.
Example 2
Investor 1: Invests 10 MSEK
Price per share: 10 SEK
Post-money valuation: 100 MSEK
Investor 1’s stake: 10 %
2 (a) Down-round occurs
Investor 2: Invests 25 MSEK
Price-per-share: 2.50 SEK
Post-money valuation: 50 MSEK
Investor 2’s stake: 50 %
Result: Investor 1 will then be diluted, and now holds 5 % of the company (pre anti-dilution protection). Investor 1 with volume weighted anti-dilution gets 600,000 additional shares based on a volume-weighted average in-price between the two investment rounds of 6.25 SEK instead of 10 SEK. Investor 1 will accordingly hold 7.8 % of the company.
2 (b) Down-round occurs
Investor 2: Invests 1 MSEK
Price-per-share: 0.90 SEK
Post-Money valuation: 10 MSEK
Investor 2’s stake: 10 %
Result: Investor 1 will then be diluted, and now holds 9 % of the company (pre anti-dilution protection). Investor 1 with volume weighted anti-dilution gets 100,110 additional shares based on a volume-weighted average in-price between the two investment rounds of 9.09 SEK instead of 10 SEK. Investor 1 will accordingly hold 9.8 % of the company.
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Variations
The alternatives presented above can of course be varied in numerous ways, for example using round size hurdles, time-limits for when and how they kick in, and other carve-outs from its application. Such variations should serve to create the right incentives for bringing in new capital into the company as well as in other aspects regarding the company’s ownership structure.
A word of caution
While the anti-dilution clause can be tempting to approve if you represent a company that is fundraising, it should be remembered that in a subsequent fundraising where the fair market value of the company is established as lower than during the first investment round, any incoming investor may refuse to invest if there is an aggressive anti-dilution clause in place. Why should they not get what they pay for but instead bear the consequences of an earlier investor’s “misguided” investment decisions and be diluted by the additional shares issued?
And if you are an investor? Remember to both consider if you have adequate anti-dilution protection in place in relation to the investment case at hand, and to ensure that you have complete information in relation to any already entered into anti-dilution clauses by the company and/or the current shareholders. You do not want to be slapped with a significant dilution immediately after your investment.
*The formula weighted average anti-dilution
SP2= SP1* (A+B) / (A+C)
S1 Share price before down round
S2 Share price price after down-round
A Fully-diluted number of shares in the company prior to the down-round (if broad based then including the assumed exercise of outstanding options and warrants etc., and if narrow based then it should only represent actually outstanding shares and disregard outstanding options etc.)
B Total consideration received by the company in the down-round divided by price-per-share
C Number of shares issued in the down round
Stockholm, April 17 2023
Author: Katarina Strandberg
Find Katarina’s website here: STG Corporate and Commercial Law AB
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