What are Anti-Dilution Provisions?

As you have probably heard, there are a lot of economic uncertainties going on in the world, which can, in certain markets, result in lower startup valuations, and those can occasionally trigger anti-dilution provisions. And what exactly is an anti-dilution provision? If you have ever looked at a venture capital term sheet, you have probably seen that term before. You probably looked at it, read the funky language, scratched your head, and moved on.

And that’s not something to be ashamed of, the language can be very wonky to understand for an untrained eye (and even for the trained eye). In short, an anti-dilution clause is something worked into venture capital term sheets to protect investors from the potential of future financings with implied valuations lower than the ongoing financing. In other words, anti-dilution rights are a protective provision preventing a company from raising a financing at a lower price than their previous financing.

First, let’s take a step back and talk what exactly dilution is and how it occurs? Most commonly, dilution occurs during a capital raising event when shares of a company are issued to new or existing investors. This causes the already existing shares to represent less of the total number of shares than they did prior to the financing event. For instance, If you have 100 shares, and raise capital by selling an additional 10 shares to a new investor, those original 100 shares go from owning 100% of the company to owning 90.9% (Old Shares divided by New Shares + Old Shares). During most capital raising events utilizing equity, this is how things work - new shares are issued and old shares are diluted. There are other ways for dilution to occur, but this is the most common way among early stage venture-capital backed companies.

For startups, it is very common, frequent and usual for equity shareholders to experience some level of dilution eventually. When you raise capital, there is only 100% of a company to go around, so when you sell some of the equity in your business (which is what you are doing in a financing), you will, by nature, be diluted. And when you raise another round of capital, everyone, including the investors from the prior round, will also get diluted.

But that’s okay! Because, in theory, that second round of financing is going to be at a higher valuation. So even though your first round investors own less of the company, what they do own is now more valuable because the overall valuation of the company is higher. This is the general idea behind almost all of finance.

I want to make it clear before I get into the next part that dilution does not mean that shares you own in a Company are less valuable than they were prior to the financing. Dilution, when it comes to private market transactions, is all about ownership stake and, in-theory, is not necessarily a bad thing. Like we previously stated, when all goes well, financing rounds lead to investments being worth more than they were at the prior financing because the per share price has been increased. More progress in the company has made with the previous investment and, thus, the company is more valuable. That, in essence, is the entire point of venture capital. Take my money and make it more valuable by building a better company. When dilution occurs, It is not as if you lose shares. Your slice of the pie does not get smaller, the overall pie gets bigger and hopefully tastier.

But anti-dilution provisions, for the most part, are not in place to prevent a company from raising additional capital. They are typically clauses in deal documents that prevent a company from raising additional capital at a lower valuation or per share price than the post-money valuation of the most recent financing. In other words, if you raise $100 at a $500 pre-money valuation, your post-money valuation is then $600. But in a year, you get into a cash crunch and have trouble raising capital, so you raise $100 at a $400 pre-money valuation, the shares of the investors from the first round of financing are now worth less than they used to be.

Of course, down rounds do sometimes happen and there are ways that savvy entrepreneurs and investors can defend against them - bridge notes, convertible loans, etc. - but what about in instances when there is no other option? Should the Company and the investor just accept the reduced equity value and move on? That’s where anti-dilution provisions come into play. In practice, these provisions essentially give additional shares to an existing investor to make up for the fact that their current investment is now worth less than it was prior to the financing event.

The most common and market-accepted version of anti-dilution provisions is the Broad-Based Weighted Average (BBWA) dilution provision. I won’t get too deep into the math here, but essentially, during a down-round, the existing shares of the preferred stock are adjusted to allow for additional shares to the equity holder. This impacts companies by more severity the larger the financing round that occurs. This is done to ensure that the investors are only compensated based on the severity of the down round and they don’t somehow come out in a better position then prior to the financing.

There are other types of anti-dilution provisions that are more rare, such as the Full Ratchet. I personally have never seen a full ratchet provision in action, but I know they are viewed as being investor friendly and some people feel very strongly about them. CooleyGo has a good explanation of a Full Ratchet provision here. The punchline is that this provision is designed to eliminate the negative impact of the down-round all together - maintaining the equity valuation for the existing investor. This of course can create several issues, but it can also significantly reduce the equity value of the management team and founders in certain scenarios.

There are a handful of additional anti-dilution provisions that you could see pop up from time to time, but they are extremely rare and I don’t really know enough about them to talk about them. But, it’s always important to keep your eyes peeled for these kinds of terms, especially in times like these. Make sure you read your term sheets and really understand them. Never be afraid to ask your VC and fellow-entrepreneurs if you don’t understand something. VC’s are ethically obliged to fully explain deal terms to you and it is their job to do so. They deal with term sheets every day so they should know this stuff down pat. And as always, consult your lawyer when in doubt.