A Primer on Anti-Dilution
Prudent investors often request some protection against the risks associated with a decrease in the value of a company in which they have invested (referred to herein as the issuer). This protection is typically effected through the anti-dilution provisions included in the issuer’s certificate of incorporation. Anti-dilution protection ensures that in the event of a down round (i.e. the issuer issues shares after the accepting the investor’s investment at a price below the price that the investor paid for her shares) the investor will suffer a more limited amount of dilution (i.e. a smaller reduction in the investor’s equity holdings).
The typical provisions relate to weighted-average anti-dilution protection. Broad-based weighted-average anti-dilution protection takes into account all securities that are convertible into, exercisable for or exchangeable for shares of the issuer’s common stock. The typical formula adjusts the conversion price for the outstanding preferred stock by reducing that price by an amount based on the ratio of shares that would be issued at the then existing conversion price, compared to the shares that will be issued at the lower offering price.
Narrow-based weighted-average anti-dilution protection takes into account only certain of the securities convertible into, exercisable for or exchangeable for shares of the issuer’s common stock. These typically include outstanding options and warrants, and outstanding convertible securities, but exclude shares issuable pursuant to a stock incentive pool or reserve. Like broad-based weighted average anti-dilution protection, narrow-based protection reduces the then current conversion price by an amount based on the ratio of shares that would be issued at the then existing conversion price, compared to the shares that will be issued at the lower offering price.
Less typical is full-ratchet anti-dilution protection, which adjusts the conversion price of the existing security to the lower price at which the issuer issues new shares. This form of anti-dilution protection is rarely granted to investors for typical angel and/or VC investments, but may be negotiated in later transactions when valuations have significantly increased between rounds.
Louis Wharton is a Partner with Stubbs Alderton & Markiles, LLP gives a brief primer on anti-dilution protection. Louis’s practice focuses on advising startup, emerging growth and middle market companies across a spectrum of industries in securities compliance, corporate finance, mergers and acquisitions and general corporate matters.font-family:Calibri'> You can contact Louis at '>[email protected] or (818) 444-4509.