What is an Anti-Dilution Clause?
Introduction
An anti-dilution clause is a provision in an investment agreement that protects existing shareholders from a decrease in their ownership percentage if a company issues new shares at a lower valuation than previous funding rounds.
Why is an Anti-Dilution Clause Important?
When a startup raises funds, it often issues new shares. If the new shares are priced lower than the earlier ones (down round), existing investors' shares lose value. The anti-dilution clause helps compensate for this loss by adjusting the ownership structure.
Types of Anti-Dilution Protection
1️⃣
🔹 What it does: Adjusts the original investors’ share price to match the new lower price.
🔹 Effect: Investors get more shares without putting in extra money.
🔹 Example:
- An investor buys 1,000 shares at ₹100 each.
- Later, the company issues new shares at ₹50 each.
- With full ratchet protection, the investor's shares get adjusted as if they had originally paid ₹50 per share, effectively doubling their shares.
2️⃣
🔹 What it does: Adjusts the price based on a formula considering both old and new shares.
🔹 Effect: Existing investors get some compensation, but not as aggressively as full ratchet.
🔹 Formula:
[
New\ Adjusted\ Price = \frac{(Old Price × Old Shares) + (New Price × New Shares)}{Total Shares After Dilution}
]
🔹 Example:
- An investor owns 1,000 shares at ₹100 each.
- The company issues 500 new shares at ₹50.
- The new adjusted price is calculated, lowering the loss impact but not fully eliminating it.
Real-Life Example
Imagine a startup raises funds at ₹200 per share, but in a later round, due to financial struggles, it raises funds at ₹100 per share. Investors with anti-dilution clauses will receive additional shares to compensate for the reduced valuation.
Pros & Cons of Anti-Dilution Clauses
✅ Pros for Investors:
- Protects from losing value in a down round.
- Ensures a fair stake in the company.
❌ Cons for Founders & Other Shareholders:
- Can dilute ownership of the founders.
- May discourage future investors due to complex share structures.
Conclusion
An anti-dilution clause safeguards early investors from losing value in a down round, but it can impact founders and other shareholders. Understanding the type of anti-dilution protection in a term sheet is crucial for both startups and investors. 📉📊