Investing in startups is a risky, uncertain, and relatively long-term investment. Entrepreneurs are, by nature, optimistic people. Investments typically take much longer to mature and yield returns. Multiple rounds of investment are usually required before most startups become cash-flow positive or self-sustaining. And each new round of investments causes the prior investors’ stake to get diluted. Investors may seek protection from dilution in the form of an anti-dilution clause. We address the following questions on this page:
- What Is An Anti-Dilution Clause?
- How Does An Anti-Dilution Clause Work?
- Are There Different Types of Anti-Dilution Clauses?
- Strict Anti-Dilution Clause
- Full Ratchet Anti-Dilution Clause
- A Weighted Average Anti-Dilution Clause
- Anti-Dilution Clause Example/Practice Question
- Tutoring for Venture Capital and Venture Finance Courses
What Is An Anti-Dilution Clause?
An anti-dilution clause protects investors from dilution in future rounds of investments. However, there is no legislated definition or protection given to an investor, and so the details of any anti-dilution clause, if provided, must be specified in the contract.
An anti-dilution clause may specify the conditions under which dilution of a specific type of investor’s stake may be permitted and the manner or quantity of dilution. More likely, the anti-dilution clause specifies when a dilution may not happen.
Dilution of ownership is a natural phenomenon when the company is growing and needs additional funds to grow. Therefore, an anti-dilution clause usually comes into play only in specific situations, such as a down round. A down round occurs when funds are raised at a valuation lower than that of prior rounds.
How Does An Anti-Dilution Clause Work?
An anti-dilution clause requires the firm to issue new shares to investors in an earlier round of financing to compensate the earlier investors for lower prices paid in the later round. As with all investment contracts, the details of each company’s anti-dilution clause must be studied in the contract. Typically, the anti-dilution clause specifies that the earlier investors will be compensated by issuing additional shares. This amount of additional shares issued is arrived at by calculating the investment made at the new down rounds’ share price. So if the investors invested $100 million at $10 per share and received 10 million shares in the prior round, but the new round was priced at $7.5/share, the investors will receive 333,333 shares, increasing their share count to 1.333 million shares (10M/7.5=1.3333 million shares total).
Are There Different Types of Anti-Dilution Clauses?
Anti-dilution clauses can be categorized into many additional types. Broadly speaking, there are three types of anti-dilution clauses.
- Strict Anti-Dilution
- Full Ratchet Anti-Dilution
- Weighted Average Anti-Dilution
Strict Anti-Dilution Clause
Strict Anti-Dilution is an anti-dilution clause where the investor suffers no anti-dilution at all. A strict anti-dilution clause ensures investors retain their ownership percentage completely in future rounds. This means that they suffer no dilution at all despite new rounds of investments! A strict anti-dilution clause is quite rare as it hinders the founders/company from raising additional capital in the future, or at least makes it more difficult.
Full Ratchet Anti-Dilution Clause
A Full Ratchet Anti-Dilution clause is an anti-dilution clause where, in the event of a down round, the investor’s ownership is adjusted to reflect the lower price at which the new round of financing is taking place. This effectively means his last round of investment is adjusted upwards as he is effectively buying shares at a lower price. This results in the investor having a larger number of shares now without any additional payment.
A Weighted Average Anti-Dilution Clause
A Weighted Average Anti-Dilution clause is an anti-dilution clause that adjusts the investor’s ownership to reflect the weighted average price in the event of a down round, taking into account the new round of financing. This effectively means his last round of investment is adjusted to the weighted average price of both his round and the new round. This also means that the investor is effectively buying shares at a lower price (though not as low as in a Full Ratchet Anti-Dilution clause). This results in the investor having a larger number of shares now without any additional payment (though not as high as in a Full Ratchet Anti-Dilution clause).
Anti-Dilution Clause Example/Practice Question
Eva started a natural cosmetics business with $15,000 in savings in Jan 2017. In June 2017, her father and friends invested $20,000 for a 10% stake. In 2018, Eva and her sister were admitted to the YC Spring cohort and received $15,000 cash for a 5% stake.
By December 2018, the brand, copyrights, R&D, patent applications, factory plans etc., were complete and Eva raised $1 million from series A investors to set up the factory and Californian sales team at a pre money valuation of $7 million.
In July 2019 Eva raised an additional $1 million from series B investors to scale up sales team across for a 15% stake.
In Jan 2021 the firm was bought by Loreal for $15 million.
What are the returns achieved for each category of investors under the following conditions. (Provide returns in MoIC and IRR). Assume investments are in the first of mentioned months.
- Series A investors has no anti dilution clause.
- Series A investors has a full anti dilution clause.
- Series A investors has a weighted average anti dilution clause.
- An options pool was introduced with a 10% equity pool along with series A round (no anti dilution).
- Series A investors has a full anti dilution clause and a 10% equity pool was introduced.
Tutoring for Venture Capital and Venture Finance Courses
GraduateTutor’s finance tutors offer live online one on one tutoring for Venture Capital, Venture Finance and related finance courses at the graduate level. Other topics we tutor on include Liquidation Preference clauses, growth vs. valuation, sustainable growth, etc. Please email or call us if we can provide you with finance tutoring for venture capital courses or any one of the other quantitative courses you will encounter in a b-school program.