Anti-dilution provisions are clauses commonly used in convertible preferred stock. They entitle investors to retain their proportional ownership if the company issues new shares in the future.
Anti-dilution provisions are usually used to protect investors when the subsequent shares are issued to new investors at a lower price.
Investors, especially venture capital firms, often require startups to include an anti-dilution clause. However, this may prove to be disadvantageous to the startup when it wants to raise capital in the future.
How anti-dilution provisions work
When a company issues new shares, it dilutes the stake of investors that already hold shares in the company. Dilution also occurs when options are exercised by their owners. In both cases, dilution results from an increase in the total number of outstanding shares.
Since this results in a decline in the value of currently outstanding shares, investors often insist on including an anti-dilution provision. The provision entitles investors to convert their preferred stock to equity stock at an adjusted conversion price.
Example of anti-dilution
Consider the following hypothetical example. Let’s say a company has 500,000 total shares issued at $1. A new investor offers to buy 500,000 shares at $0.50. This will reduce Investor A’s stake from 100% to 50% as shown in the tables below. To counter this effect, Investor A can ask for an anti-dilution provision.
Before the issue of new shares:
After the issue of new shares:
Types of anti-dilution provisions
An anti-dilution provision can be primarily of two types: full ratchet and weighted average.