Anti-Dilution Provision

An anti-dilution provision is a provision in an option or a convertible security, and it is also known as an "anti-dilution clause." It protects an investor from equity dilution resulting from later issues of stock at a lower price than the investor originally paid. These are common with convertible preferred stock, which is a favored form of venture capital investment.

An anti-dilution provision protects investors from the dilution of an equity position – something that occurs when an owner's percentage stake in a company decreases because of an increase in the total number of shares outstanding. Total shares outstanding may increase because of new shares being issued due to a round of equity financing or perhaps because existing option owners exercise their options. Sometimes, the company receives enough cash in exchange for the shares that the increase in value of the shares offsets the effects of dilution. Often, this is not the case.

In venture capital investing in particular, dilution is a concern for preferred shareholders, as a later issue of stock at a price lower than their current shares would dilute their total ownership. Anti-dilution clauses prevent this from occurring by adjusting the conversion price between preferred stock and common stock. These clauses are also known as preemptive rights, subscription privileges or subscription rights.

As a simple example of dilution, assume that an investor owns 200,000 shares of a company which has 1,000,000 shares outstanding. The price per share is $5, meaning that the investor has a $1,000,000 stake in a company valued at $5,000,000. The investor owns 20% of the company. Next, assume that the company enters a new round of financing and issues 1,000,000 more shares, bringing the total shares outstanding to 2,000,000. Now, at that same $5 per share price, the investor owns a $1,000,000 stake in a $10,000,000 company. Instantly, the investors ownership has been diluted to 10%.

Anti-dilution clauses prevent this from happening, keeping the investor's original ownership percentage in tact. The two common types of anti-dilution clauses are known as "full ratchet" and "weighted average." With a full ratchet provision, the conversion price of the existing preferred shares is adjusted downwards to the price at which new shares are issued in later rounds. Very simply, if the original conversion price was $5 and in a later round the conversion price is $2.50, the investor's original conversion price would adjust to $2.50.

The weighted average provision uses the following formula to determine new conversion prices, C2 = C1 x (A + B) / (A + C), where the variables equal the following:

C2 = new conversion price

C1 = old conversion price

A = number of outstanding shares before new issue

B = total consideration received by the company for the new issue

C = number of new shares issued