Dilution of Owners’ Equity and anti-dilution terms can be a very complicated subject for investors and startups. This article takes an overly simplified approach and focuses on dilution and antidilution in investment and how startup equity finance impacts owners’ equity. The first subject matter will be what is dilution and how do preferred shareholders’ try to protect themselves from it. While the second subject matter will cover how dilution affects the individual investor’s ownership equity when anti-dilution protections are utilized.

Diluting Owners Equity and Anti-dilution Clauses

What is dilution? Dilution is the reduction of the existing shareholders’ ownership of a company as a result of the company issuing new equity. This happens every time a company goes through an equity financing round. To help prevent preferred shareholders from having their ownership unduly reduced during a down round, an anti-dilution clause is placed in their shares. A down round is when a company offers additional shares for sale at a lower price than the per-share price sold for in the previous financing round.

Full Ratchet

The first version of this anti-dilution clause is called the Full Ratchet and is considered pro-investor. The position of the preferred shareholder receives the full effect of the down round price change when utilizing this method. This means the conversion rate the preferred shareholders can utilize when converting their preferred shares to common is fully reduced to the down rounds price. This protects the preferred shareholder’s position against dilution and encourages the company not to sell any volume of equity at a reduced rate to raise capital as this method gives no consideration to the volume of equity sold. Contact our firm to find out how a full ratchet term can be integrated into your equity or intended investment.

Weighted Average

The anti-dilution clause Weighted Average is considered more pro-company as it does not allow the preferred shareholders to receive the full effect of the down round price decrease as this clause does take into consideration the volume of equity sold. It does this by giving consideration to the number of shares given away as a total of shares outstanding and factoring the price they were sold at. This allows for only a fraction of price change to be realized by the preferred shareholders giving the company more flexibility when raising money through equity. Contact our firm to find out how to integrate such an anti-dilution term in your equity financing documents.

The above two are the two most commonly used anti-dilution strategies when structuring a round of equity raise. As each equity raise is unique to the company and investors involved, all anti-dilution terms should be prepared to meet the needs of the specific raise. Our firm is experienced in helping startup, early stage companies and investors in equity financing. Contact us for a free consultation.