This article has been written by Tanya Gupta, pursuing a Diploma in Merger and Acquisitions (PE and VC transactions) from LawSikho.

Anti-dilution adjustment clause

Many investment transactions contain the term anti-dilution. Security or mergers or acquisition agreements contain anti-dilution clauses. The anti-dilution clause provides present investors with the right to maintain their ownership percentage in the company by purchasing a proportionate number of new shares at a future date when securities are issued. Existing stockholders are exposed to a decline in ownership percentage as well as loss in the value of stockholding when anti-dilution adjustment clause is absent in security or merger agreement. This term is very significant for early-stage companies or startups.

Anti-dilution protection

To understand the concept of anti-dilution protection first we need to understand the concept of dilution. Due to incoming shares by subsequent rounds of funding, there is a decrease in shareholder’s share percentage in a company which is referred to as dilution. On the other hand, we can say when there is an increase in outstanding shares of a company then there will be a decrease in shareholder’s share percentage. Here is an example of anti-dilution protection, Suppose a company XYZ has 1000 outstanding shares, out of which A holds 250 shares. That is the investor holds 25% of shares in a company. The XYZ company issues a further 1000 shares for a subscription of shares for new investors for raising capital due to the second round of funding.

Now the number of outstanding shares increases to 2000 so it reduces the stake of A to 12.5%. The value of existing investors automatically decreases when the new shares are issued at a much lower cost than the existing investor first paid. Sometimes a situation comes when the company does not perform well so the shares are issued at a lower cost. The role of anti-dilution protection clauses is to save the existing shareholders which helps them to hold their shareholding percentage in a company to a certain level. The anti-dilution protection clause is basically given to existing shareholders when the company issues new shares due to subsequent rounds of funding at a lower rate than the price paid by existing investors.

Types of anti-dilution protection 

In India there are two types of anti-dilution protection which is available for investors:

1. Price based anti-dilution provision

• Full ratchet
• Broad-based weighted average

2. Contractual anti-dilution adjustment

3. Price based anti-dilution provision

This is a type of anti-dilution in which public subscription is given by issuing new shares which might dilute the value of shares that were held by existing shareholders. In the subsequent rounds, the price-based anti-dilution provision saves the existing shareholders from lower price shares issued by the company. The charter of a company has a conversion formula to convert preferred stock to common stock if the investors enjoy price-based anti-dilution provision. The price-based anti-dilution provision can occur in two forms.

4. Full ratchet clause

The full ratchet clause benefits the existing shareholder but it is difficult for the company. The conversion price would decrease to the price at which new shares are issued according to the National Venture Capital Association. In this concept, if the shares are issued at a lower price than the price paid by existing shareholders in the subsequent round of funding then the price of the share of existing shareholders would be revised to the price of the shares which is issued to new investors. There are two ways through which it can be done. After price adjustment, the company either issues additional shares to the existing shareholders without paying further to the company from the existing shareholder or the conversion price will be revised to the price of new shares. This concept is confined only to the price of new shares so that this price can be applied to all the shares which were held by existing shareholders. So this clause is very challenging for the company as well as for the founders of the company. This method can be understood in a better way by the following example.

For example, if an existing shareholder pays Rs 100 per share at the time of initial investment but at the subsequent round of financing new shares were issued at Rs 80 to the new shareholders now under the concept of full ratchet clause the company have to make adjustment for Rs 20 in favor of existing shareholder either by issuing additional shares or by paying monetary compensation.

There is another way for this method in which if the full ratchet is applied so the shareholding of the founders would be diluted. The demerit of this clause is that it prevents new shareholders from investing in a company. This clause only benefits the existing shareholding so it would not be the best option for new investors to invest in a company and it gives the burden of dilution to the new shareholders. The new shareholders would not be receiving any type of profits like the existing shareholders receive.

5. Broad-based weighted average

The broad-based weighted average method is adopted in many transactions since it is beneficial for the company as well as investors. Compared to the full ratchet protection method, this method focuses on the number of shares that are issued at the time of investment and at the subsequent way of funding instead of considering the price of the shares held. This method calculates weighted average price which is determined by considering the existing price of the share and the number of outstanding shares before the issuing of new shares. In a full ratchet method if the new shares are issued at a lower price than the shares are issued to existing shareholders then all the shares of existing shareholders will be considered according to the new share price. But on the other hand in the weighted average method, the number of shares issued at a lower price is considered in repricing the shares of existing shareholders.

6. Contractual anti-dilution adjustment

Under the Contractual anti-dilution adjustment, there is a contract between the company and the existing shareholders. In this clause, the company gives consent for the further issuances of shares to investors so that they can maintain their ownership percentage of shares in a company. It saves the existing shareholders from the effect of dilution of their own ownership from new share issuance in the future. 

Importance of anti-dilution adjustment clause

Importances of anti-dilution adjustment clause are as follows:

• Protects investor equity

Every investor dreams that the value of their shares increases but due to some market condition their hopes are shattered which results in their ownership at risk. It protects the existing shareholders when the company issues further shares to investors and protects the investors from market insecurities.

• Protects the company

The anti-dilution clauses benefit the existing shareholders and at the same time, it also benefits the company. When the company issues new shares to investors at a lower price than the initial investment, it results in increasing the capital for expansion and enabling the company to perform better.

SEBI’S view and problems linked with anti-dilution protection

SEBI’S views

The Securities and Exchange Board of India has strongly come out against an idea to water down the norms governing the list of small and medium-sized enterprises on the stock exchange.

Problems

According to Indian law, there are certain practical challenges that are imposed in a full ratchet type of mechanism. In the full ratchet mechanism, the shares are issued without further payment from the existing shareholders but according to the Indian company law, no shares can be issued by the company at a discount. Therefore it is not possible for a company to issue further at no cost to existing shareholders. Board members who are representing investors may face conflicts in terms of a down round. This is because directors may negotiate the terms of a down round on the behalf of the investors and also as a role of their director have to approve the transaction.

Conclusion

India is considered a famous destination for many foreign investments as it directly attracts many foreign investments. By drafting appropriate clauses in investment transactions the investment can be minimized with respect to risks and market conditions. The company should focus on financing especially so that anti-dilution protection clauses don’t come into the picture and minimizing the impact of anti-dilution protection.

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