Anti-dilution provisions are clauses that allow investors the right to maintain their ownership percentages in the event that new shares are issued. They are rights that are usually associated with preferred shares.
Anti-dilution provisions are clauses that allow investors the right to maintain their ownership percentages in the event that new shares are issued.
Dilution refers to a shareholder’s ownership decreasing as a result of new shares being issued.
There are two types of anti-dilution provisions: full ratchet and weighted average.
Understanding Anti-Dilution Provisions
Anti-dilution provisions protect an investor’s equity stake from dilution. A company may issue new shares with a round of equity financing or let its options exercised by their owners. In either case, the total number of shares outstanding will increase, while the investor still owns the same number of shares. Therefore, the investor’s percentage ownership in the company will decrease.
In some cases, the cash that a company receives for shares may offset the effect. However, usually, there will be a decline in the value of the outstanding shares. An anti-dilution provision grants an investor the right to convert their preferred shares at the new price.
Imagine you own preferred stock that you purchased for $20 per share. If the company that issued the shares goes public and issues shares at $15, the value of your investment would’ve gone down. An anti-dilution provision would protect investors from drops in value due to dilution.
Dilution refers to a shareholder’s ownership decreasing as a result of new shares being issued. If you owned 25 shares in a company with 100 outstanding shares, you would hold a 25% stake. However, if the company were to issue 100 more shares, your ownership would be cut in half. Issuing new equity will also lower the earnings per share (EPS), as the total number of shares increases. Companies may try to offset the adverse effects by repurchasing its shares.
The diagram above shows the effect of dilution on ownership. Owning 25 shares out of a total of 100 outstanding is 25% ownership. If 100 more shares were issued, ownership would be 12.5%.
When are Anti-Dilution Provisions Used?
Anti-dilution provisions are used by most companies when issuing convertible stock. The provisions are especially prominent in venture capital investing, as many rounds of financing are used. They are also used to further incentivize companies to maintain financial targets, as it allows convertible securities to remain at higher costs.
Types of Anti-Dilution Provisions and How They Work
There are two types of anti-dilution provisions – full ratchet and weighted average.
1. Full Ratchet
A full ratchet provision would protect investors who own options or convertible securities. The provision allows the investors to convert at the lowest sale price offered. Therefore, they are protected if the new offering price is lower than the conversion price on the investor’s shares.
Assume an investor owns preferred shares in Company ABC, with a conversion price of $10, attached to a full ratchet anti-dilution provision. However, Company ABC issues more shares at a conversion price of $5. The original conversion price of $10 would be lowered to $5. At the same price, the investor would then be able to purchase twice as many shares.
2. Weighted Average
The weighted average method uses a formula to determine the new conversion price.
New Conversion Price = O x (A + B) / (A + C)
O – Old conversion price
A – Shares outstanding before new issue
B – Consideration received with new issue
C – New shares issued
Imagine that during a first offering, 1,000 preferred shares are issued at $5 per share, and are convertible at a 1:1 ratio. Now, imagine the company issues another 1,000 shares; however, at a new price of $3 per share. To determine the new conversion price under the weighted average method, you would insert the numbers into the formula above.
Therefore, the new conversion price would = $5 * (2,000 + $3,000) / (2,000 + $5,000) = $3.57. Owners of the first issue of preferred shares would now be given the option to convert their shares for $3.57, rather than $5.
Comparison of Conversion Methods
The full ratchet method will always be more beneficial to owners of preferred shares, as it grants them the right to convert at the lowest available price. The weighted average method will help protect some of the value of their preferred shares. However, the conversion price will always be better than with a full ratchet provision.
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