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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.
References for Dilution
Academic Research on AntiDilution Protection
- · Equity issues and offering dilution, Asquith, P., & Mullins Jr, D. W. (1986). Journal of financial economics, 15(1-2), 61-89. This study looks at how equity offerings can affect stock prices. Regression models are used to examine price changes after announcements of equity offerings. The authors’ results show that investors generally take a negative view of equity offerings, and this is reflected in the share price.
- · Brand equity dilution: retailer display and context brand effects, Buchanan, L., Simmons, C. J., & Bickart, B. A. (1999). Journal of Marketing Research, 345-355. This research shows that a retailer’s decisions when creating displays can have an enormous effect on the perception of a brand. This effect is strong enough that it can even undo all the efforts of a manufacturer’s marketing plan. Different display approaches for a varied selection of products are discussed.
- · The effect of convertible bond equity values on dilution and leverage, King, R. D. (1984). Accounting Review, 419-431. A contingent claims valuation model is used by the authors to find the value of debt and equity in a selection of convertible bonds. By using these figures while measuring leverage and dilution, the author finds how these values affect earnings per share.
- · Dividends, dilution, and taxes: A signalling equilibrium, John, K., & Williams, J. (1985). the Journal of Finance, 40(4), 1053-1070. This paper demonstrates the inter-related nature of dividend disbursement, dividend taxes, and share price.
- · Managing brand equity., Farquhar, P. H. (1989). Marketing research, 1(3). Brand equity is a relatively new and powerful asset, and this paper allows the author to define this valuable element. The author focuses on how to build strong brands, how to maintain that brand over time, and how to leverage brand equity to protect and grow a business.
- · Understanding brand equity for successful brand extension, Pitta, D. A., & Prevel Katsanis, L. (1995). Journal of consumer marketing, 12(4), 51-64. Brand extension is a method that can allow a company to leverage their brand equity to grow their business. This paper examines the dynamic markets of the 1990s to show how the frequent practice of brand extension was used. The authors point out the strengths and weaknesses of this practice. Analysis of the brand extension is offered and recommendations on best practices are made.
- · Brand dilution effect of extension failure–a Taiwan study, Cheng-Hsui Chen, A., & Chen, S. K. (2000). Journal of product & brand management, 9(4), 243-254. This research uses data gathered from Taiwanese college students to show a failed attempt at brand extension can have negative effects on the original brand. Four different hypotheses are offered, and they find that an unsuccessful brand extension dilutes the original brand in a variety of ways.
- · Why do managers avoid EPS dilution? Evidence from debt–equity choice, Huang, R., Marquardt, C. A., & Zhang, B. (2014). Review of Accounting Studies, 19(2), 877-912. This research offers a variety of scenarios in which managers may choose to not dilute their company’s earnings per share (EPS). The role that EPS plays in compensation is examined. Differences in corporate culture, attitudes toward debt, and overall speed at adapting to changing leverage ratios are also cited as factors that affect the decision-making process regarding EPS dilution.
- · Equity dilution: an alternative perspective on mortgage default, LaCour‐Little, M. (2004). Real Estate Economics, 32(3), 359-384. This research attempts to find the real levels of leverage that are experienced by households experiencing mortgage default. This paper uses an independent estimate of junior liens combined with loan performance data to find the role that these junior liens play when increasing the risk of default.
- · Warrant pricing—Is dilution a delusion?, Sidenius, J. (1996). Financial Analysts Journal, 52(5), 77-80. This research examines the real effects that warrant pricing has on the total equity value of a firm. Pricing models are used to establish pricing in those approaches with and without the use of warrants.
- · Earnings growth: The two percent dilution, Bernstein, W. J., & Arnott, R. D. (2003). Financial Analysts Journal, 59(5), 47-55 This paper uses two different methodologies to illustrate a pair of flawed concepts that played a key role in the bull market of the 1990s. The authors suggest that misconceptions about earnings growth in relation to GDP and the role of stock buybacks in earnings growth contributed to rapid rates of growth around the world.
- · Private equity in the developing world: The determinants of transaction structures, Lerner, J., & Schoar, A. (2003). Unpublished working paper, MIT. This paper examines the challenges faced by private equity funds when trying to allocate capital in the developing nations around the world. The authors focus on the type of transaction structures used by private equity funds. By using data from 167 different transactions, they analyze the many deal structures to see how they change in response to the nature of the various countries involved.
- · Anti-Dilution Provisions in Convertible Securities, Kahan, M. (1995). Stan. JL Bus. & Fin., 2, 147. This paper analyzes 49 convertible bonds issued in 1993 to demonstrate the different types of anti-dilution provisions put in place to protect security holders against this practice. The rationale and effectiveness of these various policies and practices are examined.
- · Understanding anti-dilution provisions in convertible securities, Woronoff, M. A., & Rosen, J. A. (2005). Fordham L. Rev., 74, 129. This paper helps to provide a basic framework that introduces readers to anti-dilution provisions. The authors define the provisions, and demonstrate a number of different methods that these provisions are employed. Apparent inconsistencies in the policies are also explained.
- · Trademark dilution and the practice of marketing, Peterson, R. A., Smith, K. H., & Zerrillo, P. C. (1999). Journal of the Academy of Marketing Science, 27(2), 255-268. This article takes a look at the future of marketing and the resulting influence of the Federal Trademark Dilution Act (FTDA) of 1995. This piece of legislation was an amendment to the Lanham Act, and it was designed to protect trademarks from having their distinctiveness diminished or their positive associations tarnished by similar trademarks.
- · Quantifying brand image: Empirical evidence of trademark dilution, Magid, J. M., Cox, A. D., & Cox, D. S. (2006). American business law journal, 43(1), 1-42. This article examines a number of legal precedents related to trademark dilution. The authors refer to more than 50 years of U.S. court cases to provide context for the history and interpretation of the practice of trademark dilution.
- · Investor protection and the mode of acquisition: Implications for ownership dilution and formation of pyramids, Kim, W. (2012Financial Management, 41(1), 55-93. This paper examines how the method mergers and acquisitions can be affected by the level of investor protection in a firm. The author suggests that stock-based mergers are more likely when the investors have greater protection, and that cash-based transactions are more common when the investors experience weaker protection.
- · Management and Protection of Brand Equity in Product Configurations, Davis Jr, T. H. (1998). U. Ill. L. Rev., 59. The author examines brand equity with a focus on the relatively new subject of trade dress. He takes a look at current civil cases to see how the idea of trade dress, or the exterior configuration of a product’s appearance or packaging, as they are addressed by the Lanham Act, local courts, and even the Supreme Court.
- · Protection in the United States for Famous Marks: The Federal Trademark Dilution Act Revisited, Vassallo, E. E., & Dickey, M. (1998). Fordham Intell. Prop. Media & Ent. LJ, 9, 503. The author takes a broad, historical approach to looking at how trademarks have been treated in the US patent and legal system. This article provides both basic and in-depth information to familiarize the reader with the concept and protections of trademark dilution.
- · Defining and quantifying dilution under the Federal Trademark Dilution Act of 1995: Using survey evidence to show actual dilution, Bible, P. M. (1999). U. Colo. L. Rev., 70, 295. This work begins with a historical discussion of how trademarks were recognized and protected under law before the institution of the Trademark Dilution Act of 1995. An examination of that act follows. A survey is used to provide concrete evidence of how trademark dilution happens and how it affects the affected producers and the marketplace as a whole.
- · Executive Compensation and Corporate Governance in Financial Firms: The Case for Convertible Equity-Based Pay, Gordon, J. N. (2010). This paper proposes a new system of executive compensation that takes into account the different forces at work in financial firms that play a more significant role in the financial system. The author argues that a compensation that steers executives away from excessive risk-taking may be wisest plan for long-term stability and shareholder security.