Corporate Law Newsletter – An Overview On Anti-dilution : August 2024

Introduction

Fund-raising often spans multiple rounds such as Pre-seed, Seed, Series A, etc. Each round helps the company expand, develop new products, and increase revenue. However, challenges—both internal (mismanagement, layoffs) and external (economic crises, market volatility, pandemics)—can lead to a reduced company valuation. When shares are issued at a lower price than previous rounds, it results in a ‘down round’. Anti-dilution provisions are triggered in such cases to protect investors from the dilution of their shareholding.

When an existing shareholder holds securities having anti-dilution protection and a down round occurs, the company is obligated to issue additional securities to such shareholder with the intention to adjust their equity in the company. In case the existing investor holds convertible securities, which are subject to anti-dilution protection, the conversion price for such convertible securities is adjusted to reflect the down round per share price.

 

The Importance Of Anti-Dilution Provisions

Anti-dilution protection helps build strong investor relationships, encouraging ongoing support. Strategic investors use it to maintain a certain influence over management. However, for the company, poorly negotiated anti-dilution clauses can significantly impact founder control and ownership. Founders must be aware that the dilution from anti-dilution protection can be more detrimental than regular dilution from new share issuance.

Anti-dilution provisions can be a valuable negotiating tool. By offering protection selectively, the company can maintain leverage and flexibility in negotiations. Without such protection, an investor’s shareholding could be severely diluted.

Types Of Anti Dilution

Three main anti-dilution methods are:

1) Full ratchet method: This method ensures existing investors are issued additional securities to reflect what their shareholding would have been, if they had invested at the lower price of the down round. For instance, if a company originally had 5,000 shares, and an existing investor held 1,000 shares at INR 100 each, but a down round leads to new shares being issued at INR 50 to a new investor, the existing investor’s holding would be adjusted. Under full ratchet protection, the existing investor’s shareholding increases to 2,000 shares, raising their percentage from 20% to 25% after the down round. The total outstanding shares become 8,000 (as illustrated in Table 1 below).

 

Table 1: Full Ratchet Method Impact

Particulars	Before Down Round	After Down Round
Number of shares held by Existing Investor	1,000	(Investment Value / New Per Share Price)  i.e. 1,00,000 / 50 = 2,000  (1,000 Additional Shares)
Per Share Price	INR 100	INR 50
Investment Amount	INR 1,00,000	INR 1,00,000
Shares issued to New Investor	–	2,000
Outstanding Shares on a Fully Diluted Basis	5,000	(5000 + 2000 + 1,000) = 8,000
Existing Investor’s Shareholding	(1,000 / 5,000)% = 20%	(2,000 / 8,000)% = 25%

 

2) Broad-based weighted average method: This method adjusts the conversion price based on both pre-existing and new shares issued. This ensures that the existing shareholders are not overly penalized by the lower price of new shares. For example, if the original share price is INR 100, and new shares are issued at INR 50, the adjusted price is INR 85.71 9 (as shown in the calculation below). The existing investor’s shareholding changes from 20% to 16.27% after receiving additional shares to adjust for dilution (167 shares). The total outstanding shares rise to 7,167, as shown in the calculation below.

 

Adjusted Price = Old per share price × (OS + A) / (OS + B)

Where:

• OS = Outstanding securities issued on a fully diluted basis before the down round
• A = Securities issuable for the new investment amount at old per share price
• B = OS + number of shares issued to the New Investor at new per share price

 

Adjusted Price = 100 × [5,000 + (1,00,000/100)] / (5,000 + 2,000)

= INR 85.71 per share

 

Additional Shares = (Investment Amount) / Adjusted Price – (Number of shares held by Existing Investor before down round)

= (1,00,000 / 85.71) – 1,000

= 167 shares

 

Table 2 : Broad-Based Weighted Average Impact

Particulars	Before Down Round	After Down Round
Number of shares held by Existing Investor	1,000	(1,000 + 167) = 1,167
Per Share Price	INR 100	INR 50
Shares issued to New Investor	–	2,000
Investment Amount	INR 1,00,000	INR 1,00,000
Outstanding Shares on a Fully Diluted Basis	5,000	(5000 + 2000 + 167) = 7,167
Existing Investor’s Shareholding	(1,000 / 5,000) = 20%	(1,167/7,167) = 16.27%

 

3) Narrow-based weighted average method: This method considers only currently issued and outstanding shares, excluding unissued options and convertible securities. If the adjusted price is INR 83.33, the existing investor’s shareholding changes from 20% to 16.66% after receiving additional shares (200 shares). The total outstanding shares become 7,200.

 

Adjusted Price = Old Per Share Price × (OS + A) / (OS + B)
Where:

• OS = Outstanding securities issued on a fully diluted basis before the down round, excluding ESOP pool
• A = Securities issuable for the new investment amount at Old Per Share Price
• B = OS + number of shares issued to the New Investor at New Per Share Price

 

Adjusted Price = 100 × [(5,000 – 1,000) + (1,00,000/100)] / [(5,000 – 1,000) + 2,000]
= INR 83.33 per share

Additional Shares = (Investment Amount) / Adjusted Price – (Number of shares held by Existing Investor before down round)
= 1,00,000 / 83.33 – 1,000
= 200 shares

Table 3: Narrow-Based Weighted Average Impact

Particulars	Before Down Round	After Down Round
Number of shares held by Existing Investor	1,000	(1,000 + 200) = 1,200
Per Share Price	INR 100	INR 50
Shares issued to New Investor	–	2,000
Investment Amount	INR 1,00,000	INR 1,00,000
Outstanding Shares on a Fully Diluted Basis	5,000	(5,000 + 2,000 + 200) = 7,200
Existing Investor’s Shareholding	(1,000 / 5,000) = 20%	(1,200/ 7,200) = 16.66%

 

Table 4: Comparative Shareholding Percentages of the Existing Investor post down round

Method	Shareholding Percentage
No anti-dilution protection	14.29%
Full ratchet	25%
Broad-based weighted average	16.27%
Narrow-based weighted average	16.66%

Conclusion

To conclude, anti-dilution provisions play a crucial role in safeguarding investors’ interests during challenging times faced by the company. These provisions ensure that existing investors are protected from any reduction in the valuation of the company, thereby maintaining the value of their investment.

The choice of formula, whether full ratchet, broad-based weighted average, or narrow-based weighted average can significantly impact the shareholder equity. While the full ratchet method, provides the most protection to investors, it can substantially dilute the founders’ stake and reduce their control in the company. On the other hand, broad-based method offers a more balanced approach, protecting investors while minimizing the extent of dilution for existing shareholders. Ultimately, selecting the appropriate method is a commercial decision depending on the unique circumstances and strategic goals of each investment round.