2. Anti-Dilution Provisions

A concern of the VC could be that the firm will raise additional funding in the future by issuing shares at a price below the VC's original purchase price, a so-called "Down Round." Such down rounds can lead to severe dilution of the VC's ownership stake and thereby harm his financial interest.

To illustrate these concerns, consider a hypothetical firm that has a post-money valuation of $20 million and the following shares outstanding:

  • 10 million of Common Stock
  • 10 million of Series A Convertible Preferred with a conversion ratio of 1.

On an as-converted basis, the firm therefore has 20 million shares outstanding at a price of $1 each. The VC's ownership stake is 50%.

Now let us assume that, shortly before the exit, the firm issues an additional 20 million shares at a price of $0.1 per share to the management team. What's the impact of this "financing" round? With the newly invested capital, the value of the firm increases by 2 million to 22 million and the number of shares outstanding doubles from 20 million to 40 million.

On an as-converted basis, the new stock price will therefore be 22/40 = $0.55. As a consequence, the value of the VC's investment drops from 10 million to 5.5 million and his ownership stake drops from 50% to 25%.

Clearly, the VC will not be happy with such a capital increase because it allows the management to expropriates his financial claim!

Note that there could also be economic reasons that force the firm into a down round. For example, the business case could turn out less favorable than originally expected, or the firm could have to raise capital in an adverse market environment (e.g., during a financial crisis). Regardless of the reasons, a down round will dilute the VC's financial claim. This is why VCs generally ask for protection against the dilutive effects of such down rounds.

The workaround is very simple: If the firm engages in a down round, the price at which the VC can convert his shares into common equity (conversion price) is automatically lowered. This mechanism allows the VC to prevent strategic capital increases to expropriate investors (see example above) and it helps him maintain his fractional ownership.

Note that obviously not all investors can receive anti-dilution provisions. If the firm issues new shares to new investors, some of the existing shareholders will have to give up some of their ownership and control. Typically, these are the original shareholders (the founders), as they have no dilution protection.

 

There are two common anti-dilution mechanisms in use. They differ in the way how the conversion price is adjusted in a down round:

  • Full ratchet anti-dilution mechanism
  • Weighted average anti-dilution mechanism.

The following two subsections introduce these mechanisms and show how they work in practice.