What is an Anti-dilution Clause?

An interest in a company can become diluted when the company decides to issue additional shares in the market to seek new investors. An anti-dilution clause is a protective measure that investors can use to mitigate the dilutive effect on their interest in a company. It allows the original investment to retain its value despite the issue of additional shares.

Example

Agreements between a startup company and a private equity investor or a venture capital firm often employ an anti-dilution clause. This is because startups often involve many new investors and rounds of investing. It is necessary for original investors to not lose the value of their investment due to further investing. For more information on venture capitalists, you can read our guide on ‘What’s The Difference Between Angel Investors And Venture Capitalists?’. Imagine a venture capital firm buys 20% of a startup by purchasing 100,000 shares for $2 per share. There is an investment of $200,000. To seek further funding, the startup issues an additional 100,000 shares. A new private investor purchases the 100,000 shares but only for $1 per share (thus, investing only $100,000). You can refer to ‘Capital Raising: A Guide For Entrepreneurs’ for more information on how startups can raise capital.

Due to the additional shares, the venture capital firm’s interest is diluted from 20% to 16.67%. The venture capital firm and the new investor hold the same interest even though the new investor has invested half the amount. The venture capital firm must use an anti-dilution clause to protect its interests. Parties can negotiate the form of the anti-dilution clause based on their interests. The anti-dilution clause can offer either a “full ratchet” protection or a “weighted average” protection.

“Full Ratchet” Anti-dilution Clause

An original investor is offered common shares at the same purchase price as the new investor under a “full ratchet” anti-dilution clause. As the new purchase price is lower, the original investor’s interest is increased in accordance to the original investment.

A “full ratchet” anti-dilution clause alters the conversion ratio between preference shares and common shares. Usually, the conversion rate is 1:1 so that one preference share is equivalent to one common share. Investors hold preference shares while the founders of a company hold common shares. Our guides ‘What are the Different Types of Share Class Codes?’ and ‘Preference Shares: An Explainer’ offer more information on preference shares and ordinary shares.

In the above example, a “full ratchet” anti-dilution clause allows the venture capital firm to purchase an interest based on the new purchase price of $1 per share. This is half the original purchase price and so the venture capital firm can use the conversion rate of 2:1 to convert an investment of $200,000 from 100,000 preference shares to 200,000 common shares. This results in the venture capital firm having a greater interest in the company than it did originally, forcing the founders and the new investor to deal with a diluted interest.

A “full ratchet” protection heavily favours the original investor. Investors may use their stronger bargaining power to implement this clause into the agreement. However, companies should be careful when agreeing to this as new investors may be reluctant to invest in a company that has such a clause with its original investors.

“Weighted Average” Anti-Dilution Clause

Alternatively, an investor may use a “weighted average” anti-dilution clause. A “weighted average” anti-dilution clause also alters the conversion rate. However, it is more complex than the “full ratchet” anti-dilution clause as it considers more factors than just the new purchase price of shares. The conversion rate is altered according to the total shares outstanding and the capital that could have been raised. In the above example, the conversion rate would be greater than 1:1 but lower than 2:1. The venture capital firm would still feel some dilutive effect on its investment. Many companies prefer the “weighted average” anti-dilution clauses. In comparison to “full ratchet anti-dilution clauses, they are more neutral.

Conclusion

Investor’s can utilise anti-dilution clauses to protect the value of their investment. The clause may offer “full ratchet” protection or a “weighted average” protection. Parties should negotiate the form of the anti-dilution clause. A “full ratchet” anti-dilution may be detrimental to a company’s interests as new investors fear a dilution to their interest in favour of an original investor. Due to its more neutral nature, the “weighted average” anti-dilution clause is more common.

Most Popular Articles
You may also like
Recent Articles

Get the latest news

By clicking on 'Sign up to our newsletter' you are agreeing to the Lawpath Terms & Conditions

Share:

Register for our free live webinar today!

Tax Strategies for Small Business Success

12:00pm AEDT
Thursday 25th July 2024

By clicking on 'Register for webinar' you are agreeing to the Lawpath Terms & Conditions

You may also like

The 2024 Federal Budget has unveiled a comprehensive package of measures designed to support small to medium enterprises (SMEs) in Australia, while also laying the groundwork for a "Future Made in Australia."
Default interest clauses can help protect lenders' interests, but sometimes they will not be enforceable. Find out more here.
Lying on your resume to get a job is never a good idea. In fact obtaining employment through fraud can actually land you in jail.

Thank you!

Your registration is confirmed. Keep an eye on your inbox for an email with details on how to watch the webinar.