An investor may require a start-up to include an anti-dilution clause in the transactional agreements when looking to raise capital in exchange for equity. Venture capital investors take significant capital risks and they will always seek to minimise their investment risk however they can. It’s important that start-ups understand the effect of anti-dilution clauses on both future capital raising and the founder’s interests generally.
Dilution, in the context of equity funding, refers to the issuing of shares of a company at a price per share less than that which was paid for the shares by a previous investor. The subscription for shares increases the issued share capital of a company, leaving the existing shareholders with a smaller cut of the pie. The total number of issued shares can increase for any number of reasons, such as the issuance of new shares through a subscription for shares to raise capital or exercising share options.
Remember that not all share issuances are harmful to the shareholders. If the company issues shares and receives sufficient capital in exchange for the shares, the shareholders’ ownership percentages may be reduced but the value of the company will have increased, offsetting the lower ownership percentages of the existing shareholders. However, if the capital received is insufficient, the increase in the value of the company will not be enough to offset the reduction in ownership percentages.
In start-up and venture capital deals, the transaction documents typically include negotiated provisions designed to deal with a dilutive issuance that would otherwise reduce the value of the investors’ shares (relative to the price the preferred investors paid for their shares). These provisions are referred to as “anti-dilution provisions.”
There are two main forms of anti-dilution provisions:
- full ratchet; and
- weighted average ratchet.
Full ratchet: this is the most burdensome on the founders and can have significant negative effects on subsequent funding rounds. Full ratchet works as follow: it gives the investor the right to convert their existing preference shares at the price at which the new shares are issued. To illustrate, if an investor purchased shares at R1.00 per share and a down round later occurs in which shares are issued at R0.50 per share, the investor will have the right to convert his existing shares to R0.50 per share. This results in each preferred share being converted into 2 ordinary shares. For investors, this is great news, for Founders, not so great.
Weighted average: this is the most standard approach to anti-dilution protection. It certainly is a gentler method for handling dilution. Under a weighted average ratchet anti-dilution clause, the investors will be able to increase their shareholding at a weighted average of the new share issuance price.
A formula in the transaction documents will set out how the weighted average price will be determined and in essence be calculated based on: i) the amount the company raised before the new round; and ii) the average price per share compared with the subsequent capital raise and lower share price.
This method is the more start-up-friendly of the two types of anti-dilution clauses. The existing shareholders will still be diluting, but on better terms.
Including anti-dilution clauses in agreements is not typically in the start-up company’s best interests. However, when a start-up company is in desperate need for capital, the upside (capital) might outweigh the risk. If there isn’t a way to avoid it, you should strongly weigh the effects of the anti-dilution provisions against the need for the investor’s capital and involvement.
We trust the above has given you some insight and guidance as to why it is so important to have a good understanding of the anti-dilution provisions. If you would like to discuss any of these topics in more detail, please feel free to contact us and we’ll gladly assist.