The anti-dilution adjustment clause is a provision contained in a security or merger agreement. The anti-dilution clause provides current investors with the right to maintain their ownership percentage in the company by purchasing a proportionate number of new shares at a future date when securities are issued.
In the absence of the anti-dilution adjustment clause in the security agreement, existing stockholders are exposed to a decline in the ownership percentage, as well as a loss in the value of their stockholding.
An anti-dilution adjustment clause is contained in a security purchase agreement.
It allows current stockholders to maintain their ownership percentage by buying a proportionate number of shares when new securities are issued.
In the absence of an anti-dilution adjustment clause, an increase in the number of outstanding shares makes each share less valuable.
What is Dilution?
Dilution takes place when the number of outstanding shares increases, resulting in a reduced ownership percentage. The new shares issues increase the number of outstanding shares while decreasing the ownership stake of the current shareholders.
For example, assume that XYZ Limited holds 1,000 outstanding shares, out of which investor A owns 350 shares. It means that Investor A owns 35% of the company’s shares. In the second round of financing, the company issues an additional 1,000 shares for subscription to new investors to raise capital for expansion.
It means that investor A’s stake will decrease to 17.5% while the number of outstanding shares will increase to 2,000 shares. If the new shares are issued at a lower cost than what the current investors originally paid, the value of shares held by initial investors will decline.
Types of Anti-Dilution Provisions
There are two main types of antidilution provisions that investors can use to protect themselves against the dilutive effects of future stock issuances. They include:
1. Price-based anti-dilution provision
When a company issues new shares for subscription to the public, this issuance is viewed as a means of diluting the value of shares held by the initial shareholders. A price-based anti-dilution agreement protects investors from future issuance of shares at a price lower than what the initial investors paid.
When investors enjoy active price-based dilution protection, the company’s charter will include a conversion formula for converting the preferred stocks into common stock. The conversion rate for a Series A financing round is usually the original share issue price divided by the conversion price, with both prices set at the price per share which the company sells its Series A issuance to investors. If a down round occurs, the conversion rate will reduce, which will increase the conversion ratio of Series A to common stock.
The price-based anti-dilution protection adjustment takes the following two forms:
Weighted Average: When determining the conversion ratio in a down round, the weighted average adjustment considers the lower price and the number of new shares issued in the down round. The method uses a formula to reflect the dilutive effect of new share issuance accurately. A broad-based weighted average formula takes into account the fully-diluted capital of the company to lessen the effects of the dilution to the common stockholders.
The fully-diluted capital assumes the conversion of all convertible securities such as stock options, warrants, all preferred stock, etc. A narrow-based weighted average formula includes only the outstanding shares of stock and excludes the convertible securities.
Full ratchet: The full-ratchet anti-dilution adjustment is considered detrimental to the founders and other early common stockholders because it reduces the conversion price to the lowest price at which stock is issued after the issue of preferred stock. It does not take into account the number of shares issued.
For example, with a conversion rate of $0.50, an investor with one preferred stock will end up with twice as many common shares upon conversion. The full ratchet anti-dilution provision is rare due to the burden placed on the company’s founders and initial investors.
2. Contractual anti-dilution adjustment
A contractual anti-dilution adjustment is an agreement between the initial investors and the company, where the company agrees to issue additional shares of common stock to the investors to maintain their ownership percentage in the company until the company raises the required capital. It protects the shareholders from dilution of their ownership stake from new share issuances in the future.
It is done regardless of the price at which new issues of stock are sold. If the anti-dilution protection adjustment does not terminate when the company raises the next round of financing, new angel investors may require the company to get the individual investors to agree to terminate the protection rights before they can invest in the company.
Importance of the Anti-dilution Adjustment Clause
There are several benefits of including an anti-dilution adjustment clause in the company’s charter. The benefits include:
1. Protects investor equity
Investors put their money in an investment with the hope that the value of the portfolio will increase and that the returns attributable to them will also increase. However, sometimes, it is not always the case since market conditions may result in lower valuations than what investors expect. It will affect their ownership stake in the company.
The anti-dilution provision protects the investors from such uncertainties where the company may borrow more funds at a lower cost to the disadvantage of the initial investors.
2. Protects the common stock value of a company
The inclusion of an anti-dilution adjustment clause in the corporate charter encourages the company to seek higher valuations in new rounds of financing. It also serves as an incentive for the company to continually meet investor-determined milestones such as revenue targets and other growth objectives in order to grow the value of its common stock.
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