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When startups and investors negotiate a term sheet, it is important they understand anti-dilution provisions. Dilution is a decrease in a shareholder’s ownership percentage in a company. An increase in the total number of a company’s shares causes dilution. Anti-dilution provisions protect investors in future financing rounds from a reduction in their ownership percentage.

Causes of Ownership Dilution

Anti-dilution provisions are among the most important protections for a startup to pay attention to during negotiations. Whenever a startup issues additional equity, the increase in the number of shares outstanding can cause the existing ownership percentages held by each investor to shift. The exercise of stock options or warrants can cause an increase in the company’s total number of shares outstanding.

Anti-Dilution in Down Rounds

An increase in valuation can accompany the issuance of additional shares. In that case, the dilutive effect is often minimal. A subsequent financing round typically includes an increase in the company’s valuation. For example, a company typically receives a higher valuation in its Series B round than in its Series A round. However, the valuation of a company falls relative to its previous valuation. Then, investors may see a stark decline in their ownership percentage in the company. The decline in a company’s valuation in a subsequent financing round is called a down round.

Down rounds trigger anti-dilution provisions in order to protect investors from suffering significant losses in the value of their investments. The documents in venture capital deals frequently include anti-dilution provisions to protect investors from losses in a down round.

Anti-dilution provisions protect holders of the company’s preferred stock, not common stock.

This is achieved by adjusting the conversion ratio at which the preferred stock is exchanged for common stock. The conversion ratio specifies the number of shares of common stock an investor will receive from each share of preferred stock the investor holds. A simple formula yields the conversion ratio:

Conversion ratio = purchase price / conversion price

When anti-dilution provisions are in place, the conversion ratio rises. Therefore, preferred investors get more shares of common stock per share of preferred stock. Consequently, the shares held by the common stockholders will be more diluted.

The conversion price adjustment can be calculated in different ways. The two most common variations are full-ratchet provisions and weighted average provisions.

Full Ratchet Provisions

Among the different anti-dilution provisions, full ratchet provisions are the most favorable to preferred investors. Therefore, they are the least friendly provisions to common stockholders.

Full ratchet provisions function by adjusting the conversion price to equal the lower price share-issuance price in a subsequent financing round. As an illustration, say a preferred investor initially acquired the company’s stock at a price of $2.00 per share. If a later financing round is a down round, and the stock is only issued at $1.00 per share, then the preferred investor’s conversion price would likewise adjust to $1.00 per share. This also means that the conversion ratio has increased. The investor can exchange each share of preferred stock the investor holds for two shares of the company’s common stock.

Full ratchet provisions can have a negative impact on later financing rounds. While full ratchet provisions are highly protective of early investors in the company, they could deter some potential new investors. This is because later stage investors will not receive the full benefit of the anti-dilution provisions.

Weighted Average Provisions

Unlike full ratchet provisions, which reduce the preferred investor’s conversion price to the lower price for issuance in the following financing round, weighted average provisions involve a more complex calculation. Weighted average provisions only lower the conversion price to a value that is the average of the preferred investor’s initial purchase price and the lower subsequent financing round price.

Within the weighted average anti-dilution provisions category, there are two methods for performing the calculation—broad-based formulas and narrow-based formulas. The distinguishing factor between a broad-based and a narrow-based provision is the definition of common stock outstanding (CSO).

In a broad-based formula, the CSO definition counts both the company’s common stock outstanding (including all common stock issuable upon conversion of the company’s preferred stock) as well as the number of shares of common stock that could be obtained by converting derivative securities such as stock options. The calculation in a narrow-based provision excludes these derivative securities.

Anti-Dilution Provisions on Term Sheets

In a typical term sheet, the anti-dilution provision may look something like the following:

Anti-dilution Provisions: The conversion price of the Series A Preferred will be subject to a [full ratchet/broad-based/narrow-based weighted average] adjustment to reduce dilution in the event that the Company issues additional equity securities.

Thinking Strategically

In its term sheet negotiations, a startup should carefully consider the inclusion of anti-dilution provisions and how to structure the computation of the conversion adjustment. Decisions surrounding the anti-dilution provisions could have a significant impact later for startup founders and investors, especially in the case of a down round.