Companies typically reduce shareholder ownership when they issue new shares. This covers founders and early investors. Equity dilution occurs with companies and venture funding. This arises when new shareholders thin ownership over a wider group. Equity dilution is not always a negative occurrence. If the company’s valuation increases, the actual economic worth of an existing shareholder's stake may rise despite their reduced percentage of ownership. However, the scenario is less favorable during down rounds, where companies raise capital at lower valuations than in previous rounds. Here, not only does the percentage of ownership decrease for existing shareholders, but the real value of their last investments might also diminish.

Anti-Dilution Protections vs Pro Rata Rights

Anti-dilution protection is usually in businesses' shareholders' agreement (SHA) in early fundraising. The SHA, which describes the company's operations and shareholders' rights and responsibilities, generally protects investors. Special voting rights, liquidation preferences, and anti-dilution provisions are examples. In a downturn, the anti-dilution provision protects investors' shares by giving them free shares.

In the early stages of a company, like the pre-seed phase, anti-dilution clauses are not very common. However, from the seed stage onward, investors seek protection against dilution. These anti-dilution protections are crucial for investors with greater investments and more risk. In uncertain economic times, investors become more cautious and attempt to safeguard their assets from market volatility, focusing on such provisions.

It's important to distinguish pro-rata rights from anti-dilution protections. Usually, stockholders may participate in subsequent investment rounds by contract or legislation. This participation helps them maintain their ownership percentage. When they exercise this pro-rata right, they buy additional shares at a price set for the new funding round. For instance, they would purchase at the Series A share price in a Series A round. While this approach offers some defense against dilution, it can become increasingly expensive for early investors to continually match their pro rata rights, especially as the company's valuation skyrockets in subsequent rounds.

Calculation Methods for Anti-Dilution Shares

The important question is determining the number of "free" shares an investor is entitled to under anti-dilution protection. Three distinct methods are used for this calculation, each producing varying results based on the specific situation of the company and its capitalization (cap) table. We'll explore each method and its implications for the shareholding of a hypothetical Series B investor.

Full-Ratchet Anti-Dilution Protection

Firstly, we have the full-ratchet method. The strong anti-dilution protection is generally unfavorable to founders. Full-ratchet clauses in finance agreements are unusual and create worry. This method adjusts the investment of earlier shareholders to the lower share price of a down round. Essentially, it recalculates the entire investment based on this new price. The difference between this recalculated share quantity and the actual shares held is the number of additional shares the investor would receive. For example, if the Series B investor's entire investment were recalculated at the down round price, subtracting their current shareholding would yield the number of anti-dilution shares due.

Broad-Based Weighted Average Protection

The broad-based weighted average method is more commonly employed. This approach calculates a new average share price between the price paid by the investor in the last round and the down round's price. The subsequent step involves determining how many shares the investor would have received if their investment was made at this blended price. The shortfall between this number and their current shareholding determines the anti-dilution shares to be issued.

Narrow-Based Weighted Average Protection

Finally, we have the narrow-based weighted average method. This approach is similar to the broad-based version but with a key difference. The formula used here considers a narrower scope of outstanding shares – specifically, it only includes shares that are issued at the time, excluding options and other potential dilutive securities. The weighted share price computed using this method falls between the down-round price and the price derived from the broad-based weighted average.

Approaches to Anti-Dilution in the EU and the US

It's important to highlight the stylistic differences between European and American companies in implementing anti-dilution clauses. The descriptions and formulas previously discussed are more aligned with practices commonly seen in Central European companies and transactions. Under this European model, anti-dilution clauses typically offer the right to acquire additional preferred shares during a down round. This right is granted to counterbalance the impact of significant dilution. Depending on the specific legal framework of the country, these shares might be obtained for free or by paying nominal amounts.

In contrast, the prevalent practice in the United States takes a somewhat different route. While the core principle remains similar, the American model focuses on altering the conversion ratio of preferred to common shares. Initially, this ratio is typically set at 1:1, meaning one common share is received for each preferred share upon conversion. However, following a methodology similar to the European approach, this ratio can be adjusted during a down round. Instead of immediately receiving extra preferred shares, investors see an increase in their equivalent shareholding in common shares post-conversion.

Pros and Cons

Such legal laws have significant positive and negative consequences on companies. Investment agreements with anti-dilution provisions have perks and downsides. Investors and corporations should weigh these pros and cons based on their needs. Attorneys can help you carefully develop, negotiate, and assess anti-dilution provisions to achieve a compromise.

Anti-dilution conditions provide various advantages:

• Anti-dilution rules may make an investment more appealing, boosting investor confidence. If investors feel the business cares for and protects their interests, they may invest more.
• Anti-dilution strategies may stabilize a company's worth for further investment. These methods help existing owners and investors maintain value.

Cons of the anti-dilution provision include:

• Anti-dilution rules may hurt future fundraising. If the conditions are too difficult, investors may not participate in future startup funding rounds. Parity is necessary. Startups must balance investor satisfaction with attraction.
• Anti-dilution standards have legal implications, making compliance challenging. If not properly designed, understood, and enforced, these regulations may need lawyers and increase legal bills.
• Anti-dilution policies may conflict with investors' and the company's interests. Because it would generate further changes and dilute present investors, it may deter the business from seeking down rounds or repairing its finances.