Attracting Capital – How To Design Anti-Dilution Provisions For Investors

Offering anti-dilution provisions for investors reassures them of their ownership stake in the company regardless of future funding rounds. Such provisions make the investment attractive, raising the success ratio of your fundraising initiatives.

Understand that investors offering capital are primarily concerned about how their equity stake will be affected. Particularly when you issue new shares to raise capital for the growing company. Including anti-dilution safeguards protects investors’ and common shareholders’ interests.

Typically, these provisions form a part of venture capital funding agreements. Investors may include certain clauses that trigger anti-dilution protection. These clauses are any company activities that can diminish their percentage claim on the company’s assets.

What are Anti-Dilution Provisions?

When a company issues new shares at prices lower than those paid by investors in earlier rounds, that can cause an equity dilution. To prevent this from happening, VCs include clauses that protect them from the possibility of their investment losing value.

Anti-dilution provisions in the investor agreement or company charter are also called pre-emptive rights, subscription privileges, or subscription rights. Let’s try an example. An investor has a 20% stake in a company, and you must initiate a fresh funding round.

In that case, before offering new shares to the open market, you’ll offer them to existing investors at discounted prices. That’s how you can pre-emptively mitigate the dilution of their ownership stake in the company. Anti-dilution clauses are also included in convertible and preferred shares.

Investors owning preferred stock or convertible notes and bonds can use anti-dilution provisions to adjust the conversion prices. They can exercise this right when the company issues new shares at lower prices. Accordingly, the investor can increase the number of shares they can claim.

As a result, they can preserve their ownership stake in the company and their investment value. Such clauses can be of two kinds. For instance, full ratchet anti-dilution and weighted average anti-dilution, according to the level of protection they offer.

Understand that dilution can also occur when company employees exercise their stock options. Or when any other investors holding convertible bonds exercise their conversion rights. As the number of outstanding shares increases, each investor is left with a smaller percentage of the company.

Thus, each share loses value. Anti-dilution provisions act as failsafe measures to prevent that from happening. They act as incentives to encourage investors to inject capital into risky ventures. Typically, angels, high-net-worth individuals, and sophisticated investors require anti-dilution clauses.

What Happens During Dilution?

Let’s try an example. A company is valued at $7M, having 1,000,000 shares outstanding, where each share price is $7. An investor with a 20% stake in the company has invested $1.4M and owns 200,000 shares.

The company is now raising a new funding round and issuing another 1,000,000 shares. At the end of the round, the company now has 2,000,000 shares. But, the price per share remains at $7. However, the investor’s stake has now been diluted to 10% since they own 200,000 shares.

Anti-dilution provisions are designed to protect them from this risk. A company’s financial statements reflect the details of the provisions and how they impact possible conversions. The most common form of anti-dilution clauses applies to convertible notes and securities.

If the company issues more shares at a lower price, the clause mandates a downward adjustment in the conversion prices. Existing investors receive more shares in the company so they can maintain their previous ownership stake.

To go with the earlier example, the investor will receive an additional 200,000 shares to maintain their stake at 20%.

Understanding Types of Anti-Dilution – Full Ratchet Anti-Dilution Provision

The full ratchet anti-dilution provision states that the share price is adjusted downward. For instance, the original conversion price is $7, and the conversion price in the subsequent round is $3.5. In that case, the investor can convert their shares at the updated price of $3.5.

Full ratchet anti-dilution is a more aggressive form of investor protection. This clause instantly lowers the conversion price for investors to the company’s new discounted price. As a result, existing investors can convert their convertible notes or preferred shares into common shares.

But at the same price as the shares offered to new investors. The biggest advantage for investors is that they can preserve their ownership percentage and investment value. Their proportional stake in ownership in the company remains unchanged despite the new stock issue at lower prices.

Anti-dilution provisions for investors are particularly beneficial if the company raises a down round by lowering its valuation. From the common shareholders’ perspective, it’s a downside since their stake also diminishes considerably.

Also, raising further funding rounds can be challenging for the company. That’s because new investors will identify the risk of significant dilution in case of additional down rounds. They will likely negotiate more aggressively for terms and conditions to protect their capital investment.

You may have to agree to less favorable terms to attract capital for the company. Your decisions and financial strategies will take a hit, so make decisions after considering all aspects.

Weighted Average Anti-Dilution Provisions for Investors

Weighted average anti-dilution provisions factor in the prices of the old and new shares and their respective pricing structures. Although the formula also provides for a downward adjustment in the conversion prices, the reduction is not as aggressive.

This is why the weighted average provision is a more balanced approach to protecting the interests of old and new investors. The adjustment is moderate compared to the full ratchet anti-dilution provision and can be broad-based or narrow-based.

The weighted average provides a middle ground between the two options and protects investors from the dilution risk. At the same time, it ensures that the adjustment does not significantly impact common shareholders. Or impact the company’s capital structure and cap table.

This calculation strategy streamlines the path for future funding rounds and enables fair negotiations. The broad-based weighted average calculation factors in all the company’s outstanding shares. However, the narrow-based weighted calculation only accounts for the shares investors own.

Here is the formula used to calculate the weighted average.

C2 = C1 x (A + B) / (A + C)

C2 is the new conversion price after the funding round, and C1 is the old conversion price. “A” denotes the number of outstanding shares before the new stock issue. “B” is the total funding the company raises after selling the newly issued shares indicated by “C.”

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Advantages of Anti-Dilution Provisions

When designed strategically, anti-dilution protection helps sustain the company’s long-term growth and scalability by ensuring successful fundraising. Here’s how:

• Anti-dilution clauses make your company a viable investment opportunity, particularly for investors injecting substantial capital.
• Offering shares at discounted rates compensates investors for the potential loss in share value and ownership stake. This factor offsets the risks they take to back the company.
• Anti-dilution reassures investors that their stake is secure even after the company raises further funding rounds.
• Including anti-dilution in the initial funding rounds brings in sophisticated investors who will offer more than just capital. You can rely on them to maintain their holdings over an extended period while staying actively involved in the company’s running. You’ll also build long-term relationships with your investors and rely on them to participate in new rounds.
• Venture capitalists are likelier to remain vested in the company’s long-term success and sustainability.

Downsides of Anti-Dilution Provisions

Although anti-dilution provisions for investors have advantages, you’ll use this strategy cautiously. Here are some of the typical downsides to prepare for:

• Offering anti-dilution protection can impact the company’s valuations and your success with raising subsequent rounds. Risk-averse investors may demand lower valuations to offset the possibility of triggering anti-dilution adjustments. You’ll end up dealing with aggressive negotiations and may have to agree to less-than-favorable terms to get the needed capital.
• Although investors holding convertible notes can avail of anti-dilution clauses to secure their interests, common shareholders are at the receiving end. Once the adjustments are executed, common shareholders will be left with a lower ownership percentage.
• Companies typically have multiple classes of investors, and new investors may demand similar protection. The capital structure can become complicated and confusing when different investors have conflicting interests. Finding a middle ground is challenging, and disputes between investors are a real possibility.
• You’ll have to balance broad-based and narrow-based weighted average provisions to keep up with investor requirements.
• Calculating conversion prices and adjustments is a complex task that can delay funding, not to mention raise administrative expenses. New investors may be wary of offering capital once they learn about the anti-dilution protection existing investors have. Before funding the company, they will ask for detailed information about the clauses and their implications.

Before you think about the anti-dilution protection you can offer investors, you must know how to value your company. Check out this video, in which I explained how to do that.

How to Leverage Anti-Dilution Provisions

Anti-dilution clauses can help you attract funding from strategic investors who will back the company through its further growth stages. However, you‘ll design the clauses to align with your short-term and long-term goals and the direction to take the company.

You’ll also adopt a balanced approach to protect the interests and expectations of all stakeholders and shareholders. Here’s what you need to do.

• Before each funding round, you’ll use different valuation techniques and tools for an accurate valuation. Consider methods like market multiples, asset value, and discounted cash flows. Also, leverage the assistance of expert fundraising consultants and advisors to get precise metrics. A realistic valuation will help you set a fair share price value that will guide your fundraising strategy in terms of timing and capital amount. An accurate valuation will also set the tone for negotiations with investors and the anti-dilution provisions you can offer.
• Don’t hesitate to negotiate the protection you offer investors by aligning incentives against their expectations. Pick from tag-along, preemptive, and anti-dilution clauses and customize them according to your company’s long-term objectives. Arrive at a common ground where everyone’s interests are protected, including common shareholders.
• Do the necessary research to understand how the dilution will impact investors and the failsafe measures you can implement. You’ll develop a clear overview of the potential negative impact, which will help you devise practical solutions. Use tools like sensitivity analysis, scenario analysis, and financial modeling to explore the possible implications of dilution events.
• Adopt complete transparency when discussing dilution with your stakeholders. Reviewing and updating protection clauses occasionally to match the company’s evolving needs is also advisable.
• Explore the option of offering Contractual Anti-Dilution to existing investors. This provision entitles them to additional shares at no extra cost to safeguard their ownership stake in the company.

The Takeaway!

Offering anti-dilution provisions for investors is common among companies looking to raise funding. These provisions safeguard investor interests, particularly in the case of venture capitalists or angels who divert significant amounts of capital.

As the company owner, your objective should be to attract long-term strategic investors who will offer much more than capital. You’ll look for extended partnerships that also give you access to networks and industry-specific knowledge and expertise.

The trade-off, in the form of anti-dilution protection, could seem like a small price for the company’s sustainability and growth. Particularly if your investors could potentially participate in future funding rounds. On the flip side, protection for investors can have repercussions on other stockholders’ rights.

Be mindful of the other preferred shares and convertible securities you’ve issued and their terms and conditions. Since organizing the cap table can quickly become challenging, working with expert fundraising consultants is advisable. Keep the table clean and free of complexities.

Always factor in future funding rounds and how anti-dilution provisions for one class of investors can impact your success.

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