Anti-dilution protections: what you need to know
From start-ups to established businesses, companies will often go through a series of equity financing rounds with multiple investors. With each round of financing, the company issues new shares to the new investors which in turn reduces the existing shareholders’ ownership percentage of that company. This is referred to as a “share dilution”.
If, at a new round of financing, shares are issued at a higher subscription price than that paid by the investors at the previous round, the new round of financing is called an “up round”. If shares are issued to the new investors at a lower subscription price than that paid by the previous investors, the new round of financing is called a “down round”.
An up round only results in a share dilution. If the company is doing well, each round of investment increases the company’s pre-money valuation for each subsequent funding round which means the value of the shares that are owned by the existing investors also increases and only their ownership percentage of the company may decrease. For this reason, the scale of a share dilution on the existing shareholders (i.e. existing investors) is considered to be insignificant.
However, if the company is not doing particularly well or as expected, its pre-money valuation may decrease in subsequent rounds of financing which means the down round would not only result in a share dilution, but it will also reduce the economic value of the existing investors’ shares when the new shares are issued to the new investors at a lower subscription price. This is referred to as an “economic dilution”. Consequently, the dilutive effect of a down round for existing shareholders is much greater because their ownership percentage of the company as well as the value of their shares decrease.
What is an anti-dilution protection?
An anti-dilution protection is a right attached to a class of shares, protecting that class of shareholders from the dilutive effects of a down round to some extent. Founders and early investors often request anti-dilution protection to:
- maintain their ownership percentage of the total voting powers and thus retain control of the company; and/or
- protect the value of their investment.
Anti-dilution provisions (also known as “rachet” or “price protection”) are increasingly common in venture capital transactions and they can be found in the articles of association.
Please see our insight article for more information on the important components shaping articles of association.
Anti-dilution methods: bonus issue or adjustment of the conversion rate?
An anti-dilution provision is triggered upon the issue or grant of new securities at a down round. The definition of “new securities” is a matter for negotiation between the parties but investors usually accept that share options granted under an employee share scheme and other issues such as issue of shares in connection with certain financings are excluded.
In an equity financing round, investors are often issued preference shares which have preferential treatment over other shares and carry the right to benefit from an anti-dilution protection. If there is a down round, there are two ways to protect those investors:
- issue bonus shares; or
- adjust the conversion rate.
Bonus Issue
As compensation for the dilution effect on the existing shareholders with anti-dilution protection rights, the company can issue additional shares which may be preferred shares or ordinary shares. In order to make a bonus issue of shares, the company must have certain authorities as well as sufficient distributable profits, quasi-capital funds or non-distributable reserves to pay for the bonus shares. If the company cannot capitalise to fund a bonus issue, then the relevant shareholders normally have the right to subscribe for the additional shares at nominal value.
Adjustment of the conversion rate
As mentioned above, investors usually hold preferred shares which are convertible into ordinary shares for various purposes. Usually, the initial conversion rate is one, meaning each preferred share converts into one ordinary share. If there is a down round, the conversion rate is increased so that each preferred share converts into more than one ordinary share.
Each of the two methods mentioned above have advantages and disadvantages. For example, issuing bonus shares is preferrable for the founders and investors as they see the effect of the anti-dilution protections immediately upon the increase in their shareholding, however this does very little for the remaining shareholders (particularly employee shareholders) as they feel the brunt of any decrease in the company’s valuation and their immediate dilution is apparent. By comparison, the adjustment of the conversion rate is not very transparent, however it does allow for the anti-dilution process to be easily reversed if needs be, for instance, if the anti-dilution provision is triggered upon grant of options, but the options are never exercised.
Level of protection: full ratchet or weighted average?
As well as the method you choose to incorporate into your anti-dilution provision, you also need to decide what level of protection should be afforded.
Broadly speaking, there are two levels of protections: full ratchet and weighted average. The latter is subdivided into narrow-based and broad-based weighted average.
Full Ratchet
Full ratchet provides the greatest level of protection for the investors with the anti-dilution protection and substantially dilutes the existing shareholders. It enables the relevant investors to maintain their original percentage ownership of the company by adjusting the price that they paid for their shares to the lowest amount in each round. It is as if they had acquired their shares at the lowest down round’s subscription price per share. The amount of financing raised in each down round is not accounted for, only the price per share. For example, an investor who acquired 200 shares at a subscription price of £2 per share, would be entitled to twice as many shares if the subscription price per share at the down round is £1.
It is important to note that offering this level of protection to your current investors can make your company appear much less attractive to potential future investors due to the impact it has on existing ownership structure. As an alternative, you may want to consider replacing the full ratchet protection with one of the two weighted average approaches upon the achievement of certain milestones or performance objectives.
Weighted Average
As the name suggests, this level of protection averages the price per share by applying a formula that takes several factors into account, namely:
- the company’s issued (and sometimes to be issues) share capital;
- the price per share across different rounds of financing;
- the sum of the investment at the down round; and
- the average price per share following dilution.
Unlike the full ratchet, weighted average does allow the relevant investors’ percentage ownership to be diluted to some extent, but it also provides them with some compensation whilst also limiting the impact of the dilutive financing events on the company’s founders and existing shareholders. Therefore, it is the favoured approach and considered to be much fairer than the full ratchet.
A “narrow-based” formula takes into account the issued share capital of the company and excludes certain categories of securities from it whereas the “broad-based” encompasses all outstanding shares on a fully diluted basis, thereby includes all outstanding warrants, options, and convertible shares. Investors prefer a narrow-based formula as it provides them with a greater adjustment than a broad-based formula.
Anti-dilution protections can be a contentious topic of negotiations. As well as choosing a suitable method and level of protection, you may also need to consider other factors. For example, an anti-dilution protection disqualifies an investment under the EIS scheme. Also you might want to look at the interplay of other provisions such as pre-emption rights and “Pay to Play”. Unfortunately, discussion of these topics is beyond the scope of this article. If you’d like to know more about anti-dilution protections, we are here to help. Our experienced team of lawyers would be glad to advise you on the most appropriate approach and to assist you with drafting and negotiating the relevant provisions.
Our insights, articles and guides do not, and are not intended to, constitute legal advice or be an exhaustive review of all legal developments. Although every effort is made to ensure that the information provided in this article is accurate as of the publication date, please be aware that this is area of law may be subject to change. Please seek legal advice before applying the information provided to any specific circumstances, transactions or legal issues.