Dilution & Anti-Dilution Protection
Dilution is the reduction in the percentage ownership interest of an existing investor when a company issues new equity or the number of outstanding shares otherwise increases (exercising options, warrants, stock split, etc.). Anti-dilution provisions protect early investors from the risk of dilution by later rounds or stages of investment. Dilution is not always negative, as the value of a shareholder’s ownership may go up with the issuance of new shares. The issue is that the shareholder now owns a smaller percentage of the company. For investors who seek a return based upon their ownership percentage in the company at the time of an exit event, dilution is detrimental. The issuance of new equity at a lower price that an earlier issuance (known as a “down round”) always has a negative effect on shareholders.
Anti-dilution provisions generally protect preferred shareholders by altering the conversion ratio at which the preferred share will convert into common stock. Without some form of anti-dilution protection, the investor bears the fully risk of loss of value through any form of dilution. Anti-dilution provisions are generally divided into full-ratchet anti-dilution and weighted-average anti-dilution. While full-ratchet, anti-dilution provisions are the strongest control provisions and provide the greatest protection to the investor, weighted-average anti-dilution provisions are most common. The extent of protection afforded an investor under a weighted-average, anti-dilution provision depends heavily upon the formula used to calculate outstanding shares, referred to as narrow-based and broad-based calculations. The narrow-based formula for determining anti-dilution protection offers greater protection to investor through a lower conversion price.
Point of Conflict Between Preferred and Common Shareholders
Protecting a present shareholder from dilution in future financing rounds is a strong preference. Entrepreneurs, who possess common stock, cannot reserve anti-dilution protection for themselves, as common stock is not convertible to another form of equity. As such, investors with anti-dilution protection enjoy a benefit above that of entrepreneurs and non-preferred investors. While this control mechanism reduces the risk to the investor, it generally exposes the entrepreneur to a greater risk of dilution from later rounds of equity financing. A point of conflict arises where the special treatment of investors with regard to dilution protects the investor at the expense of the entrepreneur. This provision has the potential to introduce a point of conflict between the parties during future rounds of financing. For example, it may affect the willingness of the entrepreneur to seek future rounds of equity funding, even when additional equity funding is in the best interest of the venture. Any such point of conflict serves as a hindrance to achieving a relational contract where cooperation drives increased firm performance.