What is anti-dilution and why does it matter to me as a company founder?

When additional shares of stock are issued, that additional issuance has a "dilutive" effect on the ownership percentages of all the existing stockholders. Said another way, as the number of stockholders increases, more people are sharing the pie and each existing stockholder’s slice of the pie gets smaller. An anti-dilution provision is a mechanism that serves to mitigate the dilutive effect of future stock issuances on certain stockholders. The most common protections are designed to apply in situations in which stock is sold to new investors at a price lower than that paid by earlier investors. This article provides an overview of anti-dilution protections.

What are different types of anti-dilution protections?

• Price-based anti-dilution: When a company raises money in a “down round,” or when a company offers additional shares for sale at a lower price than the price sold in the previous financing round, that issuance is viewed as diluting the value of the stock held by the earlier investors. For that reason, investors often negotiate anti-dilution protection as part of their investment in order to offset the dilutive effects of future down rounds.
• Contractual anti-dilution: Less commonly, certain stockholders may negotiate the right to receive, for no additional payment, additional shares of stock as necessary to protect them from dilution of their percentage interest in the company from new share issuances, regardless of the price at which new shares are sold.

How does price-based anti-dilution protection work?

To implement price-based anti-dilution, the company's charter includes a mechanism to automatically adjust the rate at which preferred stock converts to common stock if the company has a down round.

Initially, preferred stock converts to common stock at a 1:1 ratio. This conversion ratio affects, among other things, relative voting rights, how proceeds in a company sale will be allocated among stockholders, and the number of shares that investors will hold in certain circumstances, such as after a sale of the company or an IPO when the preferred converts to common. When a price-based anti-dilution adjustment is made, the conversion ratio of the protected preferred to common becomes greater than 1:1, resulting in a change to the common stock equivalent number in the company's capitalization table .

There are two types of price-based anti-dilution protection:

• Weighted average: This form of protection adjusts the conversion ratio by an amount intended to offset the dilution in implied value of the shares caused by the down round. This adjustment involves a formula that compares (a) the number of shares that would have been issued to the new investors if they would have paid the same price as the earlier investors against (b) the number of shares actually issued to the new investors at the lower price. Most commonly, a "broad-based" weighted average formula is used and incorporates the fully-diluted capitalization of the company, thereby lessening the dilution impact on the common stockholders. Sometimes, the formula may include only the outstanding shares of stock (referred to as a "narrow-based" weighted average formula), which is more favorable to the early investors.
• Full ratchet: Full ratchet anti-dilution lowers the effective purchase price of the protected stock to the actual price paid in the down round. A full ratchet provision will always result in a larger conversion rate adjustment than a weighted average provision. Since it provides anti-dilution protections for preferred stockholders by more dramatically diluting common stock, full ratchet anti-dilution is more detrimental to founders and other common stockholders. Future investors might be concerned about future down rounds and future common stock dilution in companies using full rachet anti-dilution protection.

Do all preferred stock financings include price-based anti-dilution protections?

Not always. While most Series A (and later) financings include weighted average anti-dilution protection, Series Seed financings may or may not include that protection. Full ratchet provisions are not common.

Do all issuances of lower priced stock trigger price-based anti-dilution protection?

Certain issuances are typically excluded from the anti-dilution mechanism. One common exception is the issuance of options to employees and consultants pursuant to a board-approved option plan. Sometimes the charter will include a specified maximum number of excluded option plan shares. This is an important factor to consider in sizing the option pool .

Another common exception covers the issuance of warrants in connection with lines of credit. To the extent that, in connection with issuance of a warrant, the company issues any shares of stock below the price paid by the preferred stock investors, the charter should be reviewed to assess if the issuance may trigger the anti-dilution provision.

How does contractual anti-dilution work?

A typical protection entails the company agreeing by contract to issue additional shares to a particular stockholder to maintain that stockholder's percentage interest in the company until the company raises a specific amount of financing, regardless of the price at which shares are sold that dilute the proposed stockholder's percentage interest in the company.

If this protection does not automatically terminate when the next round of financing is raised, new venture capital or angel investors may require that the company get the holder of those rights to agree to terminate the rights before the new investors will invest.

Do convertible notes and SAFEs have anti-dilution protection?

Convertible notes and Simple Agreements for Future Equity, or SAFEs, do not represent a specific percentage interest in the company until converted. So, in one sense, the investors do not have stock holdings to dilute until their notes or SAFEs are converted into shares. At the time such note and/or SAFE holders convert to shares in the company, they will receive the same anti-dilution protections as the new investors in the priced round that converts the notes or SAFEs. In another sense, however, if the notes or SAFEs have a valuation cap, then that effectively provides such investors with anti-dilution protection through the date of conversion of such note or SAFE. Specifically, with a valuation cap, the issuance of additional shares by the company prior to the SAFE conversion will result in such SAFE investor having a lower relative conversion price, thus increasing the number of shares issued to such note or SAFE holder upon conversion and effectively protecting them from the interim dilution prior to conversion. In addition, notes or SAFEs may contain "most favored nation" provisions that allow the holders to take advantage of more favorable terms in future note or SAFE financings, such as a lower valuation cap.

What is my takeaway as a founder?

Broad-based weighted average protections are typical in preferred stock financings, and founders should expect to see them proposed and required by many investors. To the extent that the company can avoid down rounds and other issuances of lower-priced shares in non-exempt transactions, broad-based weighted average protections should not harm the founders. However, other types of anti-dilution protection which are less common, like full ratchet anti-dilution protection, can be more harmful to founders. These should be scrutinized carefully before you agree to them.