What is Anti-Dilution Protection?
Anti-dilution provisions protect investors from dilution when a company issues new shares at a price lower than what the investor previously paid. This situation, known as a "down round," reduces the ownership percentage and value of existing investors' holdings.
Anti-dilution provisions adjust the conversion price of convertible securities (like CCPS) to give existing investors more shares when a down round occurs, partially compensating them for the reduced valuation.
Key Concepts
- • Original Issue Price: Price paid by investor in original round
- • Conversion Price: Price at which preference converts to equity
- • New Issue Price: Lower price in the down round
- • Adjusted Conversion Price: New price after anti-dilution adjustment
- • Down Round: Financing at valuation lower than previous round
Why Anti-Dilution Matters
Understanding the impact of anti-dilution helps both investors and founders appreciate the stakes involved.
For Investors
- • Protects against value erosion in down rounds
- • Maintains ownership percentage closer to original investment
- • Compensates for taking earlier risk if company stumbles
- • Discourages founders from accepting punitive down rounds
For Founders
- • Can lead to massive dilution if anti-dilution is aggressive
- • May make raising down rounds more difficult
- • Can shift too much value from founders to investors
- • Affects motivation if founder ownership drops too low
The Balance
Anti-dilution is a reasonable protection for investors who took earlier risk, but aggressive terms (like full ratchet) can be punitive to founders. Weighted average anti-dilution is the market standard as it provides protection while sharing the pain of a down round more equitably.
Full Ratchet Anti-Dilution
Full ratchet is the most aggressive form of anti-dilution protection. Under full ratchet, the conversion price is completely reset to the new, lower price regardless of how many shares are issued in the down round.
How Full Ratchet Works
If Series A investor paid ₹100 per share and Series B is at ₹50 per share:
- • Full ratchet adjusts Series A conversion price to ₹50
- • Series A investor gets 2x the shares upon conversion
- • Investor is fully protected from the price drop
- • All dilution is borne by founders and other shareholders
Example: Full Ratchet Impact
| Scenario | Before Down Round | After Down Round (Full Ratchet) |
|---|---|---|
| Series A Investment | ₹10 Cr at ₹100/share | ₹10 Cr at ₹100/share |
| Series A Shares | 10,00,000 shares | 20,00,000 shares (adjusted) |
| Series B Price | - | ₹50/share |
| Founder Impact | 60% ownership | ~45% ownership (massive dilution) |
Founder Warning
Full ratchet can wipe out founders in severe down rounds. Always push for weighted average anti-dilution. If an investor insists on full ratchet, consider it a significant red flag or negotiate substantial offsetting benefits.
Weighted Average Anti-Dilution
Weighted average anti-dilution is the most common form. It considers both the lower price AND the amount of new shares issued, resulting in a more moderate adjustment than full ratchet.
The Weighted Average Formula
CP2 = CP1 × (A + B) ÷ (A + C)
Where:
- • CP2: New conversion price after adjustment
- • CP1: Original conversion price
- • A: Number of shares outstanding before new issue
- • B: Amount raised in new round ÷ CP1
- • C: Number of shares actually issued in new round
Why It's "Weighted Average"
The formula essentially calculates a weighted average between the original price and the new price, weighted by the number of shares. The larger the down round (more shares at lower price), the greater the adjustment. Small down rounds result in minimal adjustment.
Founder-Friendly
Weighted average shares the pain of a down round between founders and investors proportionally. It's the market standard and what most institutional investors expect. If an investor asks for full ratchet, push back firmly.
Broad-Based vs Narrow-Based
Within weighted average, there are two variations based on what shares are included in the calculation.
Broad-Based Weighted Average
Includes all outstanding shares, including:
- • Common shares outstanding
- • All classes of preferred shares (on as-converted basis)
- • Reserved but unissued shares in ESOP pool
- • Outstanding options and warrants
Result: Larger denominator = smaller adjustment = more founder-friendly
Narrow-Based Weighted Average
Includes only:
- • Common shares outstanding
- • Excludes ESOP pool, options, and warrants
Result: Smaller denominator = larger adjustment = less founder-friendly
Comparison Example
Company with 80 lakh common shares, 20 lakh preferred shares, 10 lakh ESOP pool:
- • Broad-based: 110 lakh shares in calculation
- • Narrow-based: 100 lakh shares in calculation
- • Narrow-based results in slightly worse outcome for founders
Pay-to-Play Provisions
Pay-to-play provisions incentivize existing investors to participate in future funding rounds, particularly down rounds.
How Pay-to-Play Works
- • Investors who participate in future round maintain their anti-dilution rights
- • Investors who don't participate lose anti-dilution protection
- • May convert to common stock or lose other preferences
- • Encourages investors to support company in difficult times
Founder Perspective
Pay-to-play is generally founder-friendly as it: 1) Prevents passive investors from benefiting while active investors support the company, 2) Aligns investor incentives with continued support, 3) Can simplify down round negotiations. Consider including pay-to-play provisions in your term sheet.
Negotiating Anti-Dilution Terms
Anti-dilution terms are negotiable. Here's how to approach them.
Priority Ranking
Must Have (Non-Negotiable)
Weighted average (not full ratchet)
Should Have
Broad-based (not narrow-based) weighted average
Nice to Have
Pay-to-play provisions
Negotiation Arguments
- • Full ratchet is non-standard: Market standard is weighted average
- • Founder motivation: Excessive anti-dilution hurts founder motivation
- • Future fundraising: Aggressive terms make future rounds harder
- • Shared risk: Down rounds are painful for everyone; share the pain
Calculation Examples
Example 1: Full Ratchet
Scenario:
- • Series A: 10,000 shares at ₹100/share
- • Series B (down round): 5,000 shares at ₹50/share
Result:
- • Series A conversion price adjusted to ₹50
- • Series A now converts to 20,000 shares
- • Massive dilution for founders
Example 2: Broad-Based Weighted Average
Scenario:
- • Common outstanding: 100,000 shares
- • Series A: 10,000 shares at ₹100 (CP1)
- • ESOP pool: 15,000 shares
- • Series B: 5,000 shares at ₹50
Calculation:
- • A = 125,000 (100k + 10k + 15k)
- • B = (5,000 × ₹50) ÷ ₹100 = 2,500
- • C = 5,000
- • CP2 = ₹100 × (125,000 + 2,500) ÷ (125,000 + 5,000) = ₹98.08
Result: Series A conversion price drops from ₹100 to ₹98.08 (minimal adjustment)