Protecting your investment: anti-dilution protection explained
By Abdullah Mutawi, Partner
Venture capital investments are, by their nature, a trade-off between high risk and high reward potential. Investors face considerable risk when backing companies without a solid track record of revenue generation or positive indicators of success. VC investors are fully aware that most start-ups fail yielding no returns, and rely on a small section of their portfolio to generate returns.
Given the risk involved, investors deploy a variety of methods to protect their investment value. One such method is anti-dilution protection. In this article we examine the mechanics of anti-dilution protection and offer illustrative examples to deepen your understanding of this mechanism in the venture capital preservation toolbox.
What is anti-dilution protection?
Anti-dilution provisions are designed to maintain the economic value of an investor's investment and, indirectly, can act to preserve their percentage of ownership in a given company. Simply put, it is a mechanism that allocates additional shares to investors as compensation for a reduction in the start-up’s value.
In the MENA region, these provisions are often found in the company’s shareholders’ agreement. In the United Kingdom, they are most commonly found in the articles of association, and in the United States the relevant language can be found in the amended and restated company charter or certificate of incorporation.
To better understand the possible investment risks and how anti-dilution rights can safeguard an investment's value, consider the following scenario.
1. A start-up company, at inception, has one million shares in circulation all owned by its sole founder.
2. Some time after inception, the start-up secures a Series A investment round from an investor who agrees to invest $10 million on a pre-money valuation of $10 million (meaning the share price is $10 per share).
Following the Series A round, the company's total number of shares is two million, represented by the founder's initial one million shares and the one million newly issued shares sold to the Series A investor (being the amount invested divided by the $10 price per share at the pre-money valuation). Consequently, once the investment is complete and the one million Series A shares have been issued to the Series A investor, the founder retains 50% ownership of the company, while the Series A investor acquires 50%.
At some point after the Series A capital raise, the founder and investor decide that they need to raise more capital. They do so by issuing a new round of shares in the company, the Series B round. However, in the intervening period between the Series A and Series B rounds, something has happened which results in the company not being able to secure greater than a $10 price per share in the Series B round.
Another way of looking at it is that the company, at the time of raising its Series B capital raise, has actually decreased in value from its $20 million post-money valuation. This situation is colloquially referred to as a 'down round'.
For demonstrative purposes, let's assume an extreme case where the start-up’s value has reduced substantially. Unforeseen market dynamics and intense competition have caused the company’s growth to stagnate, and new money is being raised to keep the company alive.
The company’s valuation has been reduced from $20 million down to $2 million to attract cautious investors, meaning the new price per share is $1 (determined by dividing the new pre-money valuation by the two million shares in circulation). If a new investor contributes another $10 million during this round, they will receive ten million new Series B shares.
This represents a significant deterioration of not only the company’s value but also a massive dilution to the Series A investor's ownership position. In more favourable (up-round) conditions, the dilutive impact of multiple equity rounds is accepted in exchange for an increase to the value of an investor’s shareholding.
However, when a down round occurs the latter is no longer the case. Here, the ownership position of the Series A investor has been diluted to approximately 8% and their one million shares — previously worth $10 per share (and $10 million in aggregate) are now valued at $1 per share (for a grand total of $1 million).
For the same investment amount, the Series A investor will likely see no more than one tenth of the proceeds of any sale of the company given to the Series B investor. Moreover, the Series B investor was likely issued a class of share which ranks senior to those issued to the Series A investor (meaning that, even if the company is eventually sold, there’s a strong chance that the Series A investor may not see any return at all). From the Series A investor’s perspective, this new money represents quite the sacrifice in order to rescue the company from liquidation.
To address the reduced return due to the start-up's devaluation, anti-dilution protections come into play during a down round, adjusting the overall value of the Series A investor's position by allocating them more shares. How does this happen? There are effectively two schools of thought with similar outcomes in terms of value protection.
The relevant documents might oblige the start-up to issue 'bonus shares' to the Series A investor as compensation for the decrease in their investment's value. These shares would be allocated at no cost or, if not allowed under applicable laws, at par value, at each subsequent ‘down round’. This is the most common approach in the United Kingdom.
In MENA and the US, the more common approach is to adjust the 'conversion price' for the Series A investor. Here, all shares are treated as ‘convertible’. For example, near the end of a company’s life cycle it may have the opportunity to list on a publicly traded stock exchange. In most circumstances this necessitates a single uniform class of share. The underlying idea is that all retail investors should be afforded the opportunity to purchase shares with the same rights to, for example, dividend distributions.
This is distinguished from the classic private company position whereby a single company can have numerous share classes with differing correlative rights for each class. Here the anti-dilution mechanism operates to adjust the ratio at which shares convert. The initial position is a 1:1 conversion ratio, however if the start-up completes a down round, the conversion ratio will be revised. As a result, when converting shares, the investor would receive a greater number to compensate for the reduced valuation. Rather than issue shares at each subsequent down round, as done using a bonus issue mechanism, the issuance of compensatory shares happens only at the point of conversion (in this case, being the public listing).
Regardless of whether the agreements stipulate the issuance of bonus shares or a conversion price adjustment, anti-dilution provisions are intrinsically connected to the shares' value.
So, how do we determine the quantity of 'bonus shares', or any adjustment to the conversion price, based on the price per share paid by the investor?
Calculating anti-dilution
There are three formulas available for calculating anti-dilution adjustments: the weighted average formula (of which either narrow-based or broad-based formulas can be used) and the full ratchet formula.
The full ratchet formula is straightforward; it replaces the initial price per share at which an investor has invested (in our example, $10 per share for the Series A investor) with the price per share paid by investors in the subsequent down round (in our example, $1 per share paid by the Series B investor). The mechanic is intended to put the Series A investor in a position reflecting their initial investment at the revised ‘down round’ share price.
Continuing with our example, their original investment of $10 million divided by a price per share of $1, results in a full-ratchet equity position of ten million shares. Or, an additional nine million ‘bonus shares’ for the Series A investor. Using the conversion price mechanic, the anti-dilution adjust would alter the conversion ratio to 10:1 or, ten ‘conversion shares’ for each one share owned at the point of conversion.
The weighted average formula (regardless of iteration) is slightly more complex. It evaluates the impact of the money raised and share price at the earlier Series A round against the same money raised and reduced share price at the Series B round, all weighted against the start-up’s overall value and capitalisation.
The narrow-based formula only considers a certain portion of the start-up’s capitalisation (typically excluding any outstanding options, or even certain classes of shares), while the broad-based formula accounts for the fully diluted capitalisation of the start-up (which includes the shares issued to investors, founders or employees, options over shares issuable as part of an employee incentive program, and potentially more).
Narrow-based formulas are considered more investor-friendly. By weighing the performance of the company against a smaller pool of shares, the result is a larger reduction in the conversion price (or bonus issue share price), and correlatively a larger conversion ratio (or increase in number of bonus shares), during a down round compared to the broad-based formula. In practice, the broad-based weighted average, whether applied to a conversion price or bonus issue mechanic, is most often used.
In practice
The issuance of shares under anti-dilution clauses comes at the expense of someone else, usually the ordinary shareholders whose shares do not benefit from anti-dilution protection. Because the issuance resulting from the full ratchet calculation is much larger when compared to either weighted formula (with a correlative dilutive impact), the full ratchet formula is typically seen as a draconian approach. Nevertheless, it may still be applicable or justified in specific situations, such as when an investor is rescuing a struggling start-up from certain insolvency and has sufficient leverage to negotiate this more protective (or restitutionary) version of the anti-dilution right.
Anti-dilution effectively penalises a founder’s lack of success. Investors may argue that such founder dilution is deserved because management is responsible for the ship starting to sink. However, a commonly adopted adverse view is that imposing and insisting that aggressive anti-dilution rights be triggered can have an indirect and negative impact on the future prospects of any company.
An over-diluted founder can become under-motivated and feel like an employee in the company they created. It can damage any founder/investor relationship which strains company governance and decision-making processes. It will likely demoralise any employees, who are often incentivised through equity arrangements. This in turn impacts the company’s ability to operate efficiently or raise future capital. While it may be necessary to save a company from insolvency, it can set off a chain reaction that can have the opposite of its intended effect if not managed correctly.
What’s consistent across any discussion of anti-dilution rights is its emergence when considering a price reduction. This makes navigating a ‘down round’ in practice more than merely a legal discussion. The market’s negative sentiment for a company faced with the harsh reality check of an impending down round is incredibly difficult to overcome.
Potential investors, wary of a company’s slowing growth and uncertain prospects, will likely be hesitant to inject fresh capital. It is a negotiation with complex commercial, often personal, components which only serve to compound the value of transaction management and a strong communications strategy.
In practice, all alternatives are explored before proceeding with any bonus issuance or conversion ratio adjustment. It’s not uncommon for founders or incoming investors to accept separate economic or governance diminutions, or in more nuclear scenarios, wholesale share capital restructures, in exchange for a waiver of the existing investor’s anti-dilution rights. In this sense, even though a negotiated outcome may disenfranchise an existing investor of their anti-dilution rights, their existence can provide substantial leverage in any negotiation.
