How to Protect Your Shareholding from Dilution

When you invest money in a company in which you are not a founder (especially early-stage startups / seed rounds), you will want to take a careful look at anti-dilution protections in the company’s shareholder agreement. If you tip in $100 for a 25% share of a company, you will want to make sure that you retain that 25% slice even if the company gets further investment down the line - this is one important way in which you can protect your shareholding from being diluted.


Ordinarily, anti-dilution provisions will work together with the issue of preference shares, and will come into play with the conversion of preference shares into ordinary shares. (If you’re wondering what the hell preference shares are, take a look at our quick low down on share classes).

There are two main forms of Anti-Dilution Clauses:

1. Full Ratchet Anti-Dilution

The full ratchet is a bit easier to calculate than the weighted average ratchet below - it is basically taking the lowest price per share that shares are being sold at, and allowing an existing preference shareholder to convert their preference shares to ordinary shares at that lowest price.

So how does a full ratchet anti-dilution provision work?

  1. You originally invest in a company (buy preference shares) at $100 per share. Originally the deal is that your preference shares convert at the rate of $100 per share.
  2. The company decides to raise more money at $50 per share (sometimes called a ‘down round’ where the price per share is lower).
  3. With a full ratchet anti-dilution provision, your preference shares can now convert to ordinary shares at a rate of $50 per share, effectively doubling the number of shares you might have originally received.

The original investor receives more shares without the need for additional payment to ensure that their level of ownership in the company remains the same.

Although full ratchet anti-dilution clauses can be easier to implement from a practical perspective, they can have some disadvantages:

  1. Often the founders will be the ones who end up being diluted significantly.
  2. The dilution of founders can act as a disincentive or deterrent to them - they essentially now own a smaller percentage of their business.
  3. Having full-ratchet provisions might deter future investors who can see that they are getting less bang for their buck - if a company is already having to do a down round, then having a full ratchet can make that even harder.
  4. All of the above can have an overall detrimental effect on the company’s overall valuation.

Generally speaking, weighted average anti-dilution clauses are preferred.

2. Weighted Average Ratchet Anti-Dilution

Under a weighted-average anti-dilution protection, the price at which an original investor converts their preference shares is adjusted based on a ‘weighted average’ of the price at which any new shares are issued. So if the company only issues a really small amount of new shares at a different price per share, the original investor’s conversion price will only change by a bit. Similarly, if the company issues a larger chunk of new shares, then the original investor’s conversion price will move significantly. Weighted-average anti-dilution provisions can be either ‘broad-based’ or ‘narrow-based’ - the difference between ‘broad-based anti dilution’ and ‘narrow-based anti dilution’ is the total shares which they take into account when calculating the weighted average, such that broad-based takes into account shares that have not yet been converted (e.g. outstanding employee options) whereas narrow-based does not.

Yeah, this is more complex to calculate, but our worked example of weighted-average anti-dilution provisions will help make more sense of this.

  1. You originally invest in a company (buy preference shares) at $100 per share. Originally the deal is that your preference shares convert at the rate of $100 per share.
  2. The company decides to issue some more shares at a price which is less than $100 per share.
  3. If you have weighted-average anti-dilution provisions, here is the formula to help you work out your new conversion price:

where:

CP2 = New Conversion Price

CP1 = Conversion Price for your preference shares in effect immediately prior to issue of new shares

A = Number of ordinary shares issued in the company immediately prior to issue of new shares

B = Total funds received by the company for the issue of new shares divided by CP1

C = Number of new shares to be issued

Using this formula means that the conversion price will move depending on the number new shares issued as a proportion of existing shares.

Weighted-average anti-dilution protections are normally preferred over full ratchet provisions because it tends to be friendlier to founders, and also because it appears more ‘fair’ - adjusting the price based on the number of actual shares issued rather than the full ratchet where the price can change due to the price of a single share.

Overall, anti-dilution protections are designed to protect shareholders from losing the slice of the pie in which they invested if a company issues shares at a lower price. Unfortunately the anti-dilution provisions don’t really help where the company issues share to new investors for a higher share price than the original investor bought in at, but hopefully the preference shares have other protections such as pre-emptive rights (also called a right of first refusal) that at least gives them a chance to retain their slice of the company pie!

What have your experiences been with anti-dilution provisions? Do you think weighted-average or full ratchet is better and why? Comment below.