Anti-dilution provisions are commonly included in a company’s articles of association and/or investment agreements when capital is raised from third-party investors. The legal mechanics of these protections have been explored in my colleague’s recent article, Anti-dilution provisions: Protecting investor value in down rounds.
These provisions are designed to protect early-stage investors in the event a company raises funds at a lower valuation than in a previous round (a ‘down round’). Their core purpose is to preserve the economic value of the investor’s original investment by redistributing dilution to other, unprotected shareholders, typically founders and management.
The practical effect—particularly in the context of a down round—is often less clearly appreciated at the outset. This article therefore examines how anti-dilution provisions operate in practice, focusing on:
- the relative aggressiveness of different forms of protection;
- their impact on the company’s cap table, and how they can materially alter the level of dilution experienced by different shareholders; and
- the broader effect that differing contractual protections have on different shareholders.
The most common type of anti-dilution protections
Full ratchet
Under a full ratchet, the investor’s investment price is re-priced to match the new lower price, regardless of how many shares are issued as if they had invested at that valuation from the outset.
If an investor subscribes at £2.00 per share and a subsequent round is priced at £1.00 per share, the investor’s position is adjusted as though they had invested at £1.00, doubling their effective ownership.
Weighted average ratchet
This is a more balanced mechanism whereby the investor’s investment price is re-priced based on both the lower price and the number of shares issued in the new round.
Weighted average anti-dilution adjustments are calculated using specific formulae and unlike a full ratchet, the effect of the ratchet will depend on the number of shares issued. A minimal issue of shares at £0.50 will have a significantly smaller dilutive effect than a large capital raise at the same.
The weighted ratchet can be:
- broad-based (including unexercised options and other convertibles — less dilutive); or
- narrow-based (only the actual issued share capital — more dilutive).
- The two primary mechanisms used to implement anti-dilution protections:
Primary mechanisms used to implement anti-dilution protections
Bonus issue
Additional shares are issued to the protected shareholder at nominal value to adjust their ownership percentage and compensate for the lower price of the new issue; and
Conversion adjustment
The conversion price of the preference shares for the protected shareholder is reduced to reflect the lower price of the new shares, thereby increasing the number of ordinary shares the protected shareholder is entitled to receive on conversion.
How anti-dilution operates on the cap table
From a cap table perspective, the extent of dilution will depend both on the type of ratchet applied and on the method of implementing the anti-dilution protection.
Some points to consider:
- bonus issues are immediately visible on the cap table and therefore promote clarity and transparency for all shareholders;
- conversion adjustments avoid the need to issue additional shares upfront but may involve more complex recalculations and can be less transparent on the cap table;
- a full ratchet offers maximum protection for an existing investor but is highly dilutive to non protected shareholders and is therefore often resisted in practice, as it may make the company less attractive to future investors;
- a broad-based weighted average ratchet, combined with a bonus issue, is often seen as a balanced compromise between protecting existing investors and limiting dilution for unprotected shareholders as it provides investors with meaningful protection while limiting the impact of dilution on the unprotected shareholders;
- on sale, exit or IPO, a bonus issue preserves the original liquidation preference per share, whereas a conversion adjustment may affect equity and voting dynamics and can complicate the operation of liquidation preferences.
Key investment agreement provisions and the impact
Overly aggressive anti-dilution protections can deter prospective investors, complicate future fundraising rounds, and result in significant dilution for founders, potentially affecting control thresholds. It is therefore important to strike an appropriate balance between protecting early investors and the need to attract new capital as the company grows. The following points are therefore commonly considered and negotiated in reaching this balance:
Pre-emption rights
Minority shareholders are generally unable, acting alone, to block shareholder resolutions approving the issuance of new equity securities. As such, an outright veto right over new share issuances represents one of the strongest forms of anti-dilution protection available to an existing investor.
In practice, however, such veto rights are relatively uncommon. This reflects the commercial need for companies to retain sufficient flexibility to raise additional equity capital, particularly where debt finance may not be available or appropriate. Accordingly, investors will more typically rely on a combination of contractual protections such as pre-emption rights and weighted average anti-dilution mechanisms rather than an absolute prohibition on new issuances.
Pay to play
These provisions require investors to participate in future funding rounds in order to retain the benefit of anti-dilution protections whereby an investor is required to participate and take up a specified minimum proportion of its pro rata entitlement.
The provisions may operate to reward participating investors—for example, by granting them additional shares with enhanced economic rights or a more favourable class of shares. Conversely, such provisions can penalise non-participating investors, including by removing anti-dilution protections or requiring their existing shares to be converted into a less preferential class with reduced rights.
Ownership Thresholds
Where equity stakes fall below a critical threshold, founders risk losing effective control of the company, potentially being diluted to the point where they no longer have meaningful influence over its direction.
Consideration should therefore be given to the categories of investors benefiting from anti-dilution protection. To preserve the company’s ability to raise further capital, it is common for a company to restrict granting anti-dilution protection rights to investors whose equity ownership exceeds an agreed minimum threshold.
Carve-outs
In some cases, issuing new shares at a lower price may be necessary, and founders may argue that anti-dilution provisions should not apply in such circumstances. Certain issuances to be excluded from the scope of anti-dilution protection include:
- shares issued under employee share incentive schemes;
- the conversion or exercise of pre-existing options or other convertible securities; and
- shares issued for strategic purposes or in connection with acquisitions.
- Duration Limits
Anti-dilution protection may be time-limited (for example, to the first two years following an investment), providing early-stage investors with protection when the risk of a down round is highest, while allowing the company greater flexibility to raise capital as it matures.
How Moore Barlow can help
Anti-dilution provisions are a key tool for managing downside risk from capital is raised from third-party investors. Careful drafting and modelling are essential to ensure these provisions support, rather than hinder, long-term value creation. Our Corporate lawyers can advise on how to strike the appropriate balance between investor and founder protections.
