In the fast-paced world of venture capital, company valuations can shift rapidly. When a business raises new capital at a lower valuation than in a previous round, a so-called “down round”, early investors risk seeing their ownership diluted. To mitigate this risk, investors often negotiate for anti-dilution protection as part of their investment terms.
What are anti-dilution provisions?
Anti-dilution provisions are contractual mechanisms designed to protect certain shareholders, typically venture capital investors, from a reduction in their percentage ownership or economic interest when new shares are issued at a lower price than they originally paid. These provisions are generally included in a company’s articles of association and apply to specific classes of shares, most often preferred shares.
In practical terms, anti-dilution protection ensures that an investor receives either through the issue of additional shares or by adjusting the conversion terms of their existing shares, thereby preserving the economic value of their original investment.
How anti-dilution provisions operate
Anti-dilution protection is typically triggered when a company issues new securities — including shares, options, warrants or convertible instruments — at a price below that paid by the protected investor. Not every issue of new shares will activate the provision; most investment agreements will expressly carve out certain permitted issuances, including:
- Shares or options issued under an agreed employee incentive scheme;
- Further subscriptions by the same investor, such as where investment is made in tranches linked to milestones;
- Pre-agreed share issuances in the investment documents or those made with the investor’s prior consent; or
- Shares issued in connection with bona fide debt financings or leasing arrangements.
Two common mechanisms
There are two main ways to implement anti-dilution protection:
Bonus share issuance
Under this approach, the company issues fully paid bonus shares to the protected investor to restore their economic position. The authority for such an issue must be built into the articles of association, and the company must have sufficient reserves to capitalise. This method provides immediate visibility of the adjustment, but its transparency may demotivate unprotected shareholders, typically founders or employees, who see their shareholding further diluted.
Conversion rate adjustment
More commonly used where investors hold preferred shares, this method adjusts the rate at which those shares convert into ordinary shares. For example, a 1:1 conversion rate may be adjusted to 1.5:1 or higher following a down round. This approach delays the visible impact of the adjustment until conversion and is often favoured for its less immediate psychological effect on the broader shareholder base.
Types of anti-dilution protection
The extent of protection varies depending on the formula agreed. The two most common methods are:
- Full ratchet: This is the most investor-friendly (and founder-unfriendly) form of protection. It adjusts the original investment price to match the new, lower price, as though the investor had originally subscribed at the down round valuation. It can result in substantial dilution for other shareholders and is often resisted by founders and management.
- Weighted average ratchet: This more balanced approach adjusts the investor’s position based on the volume of shares issued in the down round, not just the price. It blends the old and new share prices, factoring in the total capitalisation of the company. Weighted average ratchets can be:
- Broad-based, considering all outstanding equity and convertible instruments; or
- Narrow-based, considering only issued shares.
Broad-based ratchets are more equitable and less dilutive to management shareholders than their narrow-based counterparts.
- “Pay to Play”: an investor commitment mechanism: Some anti-dilution provisions include a “pay to play” clause. This means that an investor must participate in future funding rounds (typically by subscribing for a set percentage of their pro-rata entitlement) to retain the benefit of anti-dilution protection. Failure to do so may result in their shares being converted into a less favourable class that does not carry anti-dilution rights. This mechanism incentivises continued investment and helps avoid a situation where inactive investors continue to enjoy preferential rights.
Which method is best?
Each method has its advantages:
- Bonus share issuances offer immediate transparency on capitalisation but may demoralise unprotected shareholders.
- Conversion rate adjustments provide less short-term visibility but can be simpler to manage in ongoing funding rounds.
In practice, the right approach will depend on the investor’s priorities, the stage of the company’s lifecycle, and the negotiating strength of each party.
Conclusion
Anti-dilution provisions are a critical tool for managing risk in venture capital investments. However, they must be carefully tailored to balance the interests of investors with the need to incentivise and retain key personnel. Overly aggressive terms may deter future investment or undermine the team’s commitment.
As ever, the key lies in clear drafting, commercial foresight, and a solid understanding of the practical and legal mechanics involved.
How can Moore Barlow help
At Moore Barlow, our experienced corporate lawyers regularly advises founders, directors, and investors on the legal and commercial aspects of equity arrangements, including anti-dilution provisions. Whether you are negotiating investment terms, planning a funding round, or restructuring your shareholder base, our partners bring deep expertise and practical insight to help you navigate these decisions with confidence.
We understand that protecting investor value while maintaining a balanced and incentivised shareholder structure is critical to long-term success. Our advice is clear, commercially focused, and tailored to your specific goals, whether you are raising capital, preparing for an exit, or managing shareholder dynamics in a growing business.
Please don’t hesitate to get in touch with our team if you would like to discuss your options. We would be delighted to assist.
