What is Dilution? What are Anti-Dilution Protections?
Dilution: the reduction of the percentage of a company a shareholder owns;
Dilution is a normal part of investing in startups due to the number of funding rounds often involved;
Dilution is not normally a problem because each new investment round increases the company’s total value more than a current shareholder loses for owning a small percentage of the company;
BUT, when that doesn't happen -- when the valuation of the company is lower in a new investment round than it was in a previous investment round (i.e. a down round), the shares held by existing shareholders are worth less than what they cost;
To avoid losing all that value in the event of a down round, almost all investors insist on Anti-Dilution Protections. This are two main kinds of protection:
Full Ratchet Anti-Dilution Protection: Most effective for investors, reduces the conversion price of existing preferred shares issued to the price of new preferred shares issued in a down road;
Weighted Average Anti-Dilution Protection: offers less anti-dilution protection than a full ratchet but, critically, greatly reduces the risk of de-motivating founders and still makes investors want to invest in the next round (a decent compromise solution).
Anti-Dilution Protections Explained
Dilution refers to the reduction of shareholder’s overall ownership stake in the company when the company issues new shares, thereby giving them a smaller slice of the overall pie. (For instance, a shareholder who holds 100 out of 1000 issued shares owns 10% of the company. But when the company issues another 1000 shares, that same shareholder gets ‘diluted’ down to only owning 5% of the company).
Dilution is a very, very common process with startups; since startups usually do one financing round after another, an early shareholder may end up getting diluted multiple times before the company is ultimately acquired, goes public or liquidates.
And usually, this is not a problem for the company’s existing shareholders – while an existing shareholder’s ownership percentage will go down in a financing round, usually the overall valuation of the company is significantly increased in the new financing round and that existing shareholder’s shares end up being worth much more than before.
Sometimes, however, a company’s valuations don't always stay on an upwards trajectory when going into its next financing round – usually because the company has run into serious problems (lack of sales, bad management, too much competition, etc.) and is just not attractive to new investors at a higher price point.
When a company ends up raising money at a valuation lower than a previous financing round, the price of the new series of preferred shares sold to the new investors is lower than the preferred shares sold to earlier investors. When this happens, it is usually referred to as a “down round”, and shares held by existing shareholders are worth less than what they cost.
When a down round happens, the earlier shareholders face the risk of getting diluted without receiving any of the usual benefits of a significantly higher overall value to their shares.
Because this scenario is such a serious threat to startup company investors, in almost every equity financing round there are specific legal provisions to make sure that the impact of this danger is either seriously reduced or removed altogether, also known as Anti-Dilution Protection.
Two of the most common forms of Anti-Dilution Protections that you see in startup financing deals are Full Ratchet and Weighted Average Anti-Dilution Protection. We expand upon both next.
Full Ratchet Anti-Dilution Protection
Full Ratchet protection, the most protective form of Anti-Dilution Protection, eliminates any dilution consequences to prior investors in the event of a down round.
A Full Ratchet works by reducing the conversion price of existing preferred shares issued to the price of new preferred shares issued in a down road. And by “conversion price”, we are talking about the ratio for converting 1 preferred share into 1 common share, which may be very important in connection with an acquisition or other company exit.
So, with a Full Ratchet, if a Series A investor purchased her shares at a $1.00 per share and then there was a down round where Series B shares were sold for $0.50 per share, the conversion price for the Series A investor would get lowered to $0.50 per Series A share, and the Series A investor would be able to convert her Series A shares into common shares at a 2:1 ratio.
While this kind of protection is great for investors, it’s actually much less common to see than Weighted Average Anti-Dilution Protection.
The biggest problem with a Full Ratchet is that the founder often ends up getting so diluted that she just doesn’t have any motivation to work as hard as necessary to make the company a success (and that motivation is extra important when a company is in trouble).
Another issue is that it can be difficult to encourage series A investors to participate in a B round, if the share price has reduced between funding rounds. Similarly, it could also dissuade series B investors to participate in future rounds for the same reason.
Weighted Average Anti-Dilution Protection
This form of protection is the ‘standard’ form of Anti-Dilution Protection that you see in financing rounds these days. It is a compromise where instead of having the founders alone to suffer all the dilution consequences of a down round, those are shared between the founders and the existing investors – this way, the problems posed by a Full Ratchet are somewhat mitigated.
Take a look at what this means in practice: We have published a formula to help founders understand what Weighted Average Anti-Dilution Protection looks like, and what that might mean for their shares, if a startup were to go through a down-round.
This article was the third in our series aimed to provide information to early-stage startups that are looking to raise significant funds by selling shares in the startup to investors. Please see our first article about Preferred Shares here and second about Dividend Preferences here.
Disclaimer: This article constitutes attorney advertising. Prior results do not guarantee a similar outcome. MGLS publishes this article for information purposes only. Nothing within is intended as legal advice.