This article has been written by Prince Pathak, pursuing a Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho.

Introduction

The two most common forms of shares are equity and preference shares. Equity shares provide investors voting rights in a firm, but preference shares offer a distinct edge when it comes to generating dividends and repaying the money. In common parlance, preference shares are provided to investors with specific rights such as liquidation preference, preferential rights, anti-dilution rights, and dividend rate. Anti-dilution is a word that appears in many investment contracts, and comprehending the finer points of these agreements is crucial for a startup or early-stage company. In this article, the author has tried to explain anti-dilution rights in an agreement, types of anti-dilution protection, and explained the anti-dilution clause in an investment agreement in light of the COVID-19 pandemic. 

Focussing on the concept of anti-dilution

The concept of anti-dilution is also associated with the ‘down road funding’ in the business world; down-round funding refers to when a private company raises additional capital by issuing shares at a lower price than the previous round of funding. 

Dilution signifies the decrease in the shareholding percentage of a shareholder, so when a company receives a subsequent round of investment, the shareholding percentage of the existing investors gets diluted. Hence, when the company issues new shares following a later round of investment at a price lower than the price paid by the existing investors, then the anti-dilution protection granted to the existing investors comes to play. There has been no clear advice on the technicalities of anti-dilution laws in any Indian legislative text or judicial judgment too far. Anti-dilution rules, widespread in western legal contexts, are essentially unknown in Indian law and lack a solid legal grounding.

Anti-dilution protection

The investors highly negotiate the anti-dilution. It appeals to investors because the Investor equity is protected by the anti-dilution provision, which encourages them to invest more. There are a few options for a company to examine the unwelcoming downturn. The following options are more common in the private equity world. 

• Cost-cutting- Cost-cutting by a company might be a temporary remedy that prevents the need for an immediate external fundraise by the company.  
• Bridge financing- If a firm is experiencing a short-term liquidity constraint, it can turn to convertible note financing, which allows the company to convert its convertible notes in the following round at a discount to the price established in that round.
• Make an effort to get a waiver- Many founders seek to renegotiate the terms of the company’s contract with an existing investor, and it is typical to find that excellent management negotiating skills may result in current investors surrendering their anti-dilution rights, avoiding the founders’ downfall.

Although the options listed above may not be a long-term answer to escape a down round, there are two types of anti-dilution protections that are more common in Indian jurisdiction. While finalizing any investment agreement, these protections are highly negotiated, and they are “full ratchet and weighted average methods.” However, there is one more anti-dilution protection that is “Narrow-Based Weighted Average Anti-Dilution Protection.” 

Full ratchet

Under this approach, if shares are issued at a subsequent round of investment at a price per share that’s not up to the value per share paid by the prevailing/existing investors of the corporate, then the value of the shares/ conversion price of the present (existing) investors are revised to the value at which the new shares being issued. Full-ratchet protection is the most advantageous from the viewpoint of any investor because the existing investor’s shareholding is adjusted based on the reduced per-share price offered as part of the down-round, i.e., by modifying the conversion price and conversion ratio of the securities held by the investor.

• “Say you originally have a company with 100,000 shares and a share price of $10 per share. You now issue 100,000 shares in your Series A at the price of $10 per share representing an investment of $1,000,000. At the end of Series A, you will hold 100,000 shares out of a total of 200,000 representing 50% of the company. If the Series A price gets repriced to $9 per share, the investment remains $1,000,000 but they now represent 111,111 shares; your ownership is decreased to 100,000 / 211,000 or 47%.”

Broad-based weighted average

Both investors and founders often agree to a broad-based weighted average protection since it is a more balanced and equitable mechanism in which non-anti-dilution shareholders do not fully absorb the dilution impact. It considers several factors, such as the original investment’s valuation, the amount to be raised in the down-round, the number of shares to be issued, and so on, before determining a revised conversion price (the “Adjusted Conversion Price”), which will increase an existing investor’s shareholding percentage in a down-round. 

Narrow-based weighted average anti-dilution protection

“The narrow-based weighted average method of anti-dilution, as the name suggests, narrows the base of shares used in the formula. This results in a lower conversion price and the investor gaining higher percent ownership. This provision ensures that investors aren’t penalized when companies issue new shares”. The formula for narrow-based weighted average protection is quite similar to the formula for broad-based weighted average protection mentioned above. The only difference is that unissued stock options, warrants, and shares to be issued upon debt conversion/exercise and other similar instruments are excluded from the calculation of outstanding shares, leaving only those currently issued and outstanding shares. Narrow-based protection is not common in India, but it is preferable by investors in western countries.

However, the anti-dilution provision has a few exceptions to its application. As an exemption to the businesses’ use of the anti-dilution right, the following might be incorporated in a shareholders agreement:

• Employee Stock Options (ESOPs),
• Shares issued for consideration other than cash and this usually happens in scenarios of the merger, amalgamation, acquisition, consolidation, etc.,
• Shares with respect to which the holders of a majority of the outstanding Series A investors waive their anti-dilution rights.

Anti-dilution in COVID-19 

The COVID-19 disruption and subsequent market downturn have had a significant negative impact on valuations. Unfortunately, many Indian firms will be racing to reorganize their businesses and obtain finance at reduced enterprise valuations. As enterprises seek additional funding in this new environment, “down rounds” and fundraising at a lower level are becoming more common. 

We all know that down rounds have undesirable consequences. Still, they may be necessary at a time when the pandemic has had a severe influence on the national economy, and the financing situation is bleak. Now, a big question loom can founders modify their term sheet in order to protect their start-ups/business? Founders must ask to modify the term sheet. The majority of experts believe that it is primarily dependent on discussions between company founders and investors and differs from situation to situation. Founders can also take the help of “pay-to-play provision,” and it can be helpful for entrepreneurs in protecting their business. Founders of emerging economies frequently negotiate anti-dilution provisions with a pay-to-play condition, which requires investors to spend proportionally to their ownership in future funding rounds to be entitled to certain rights, including anti-dilution protection. In other words, “a pay-to-play provision in a term sheet requires existing investors to cooperate, at the company’s request, in following financing rounds on a pro-rata basis or stand to lose some or all of their rights.” And according to the experts of leading law firms in India and have suggested that “before enforcing their anti-dilution rights, investors usually evaluate a number of criteria (e.g., the impact of enforcement on the management team, future capital raising ability, etc.).” 

Now, talking about the non-Indian investors, applications for anti-dilution rights enforcement will need to take into account RBI clearances, which are given on a case-by-case basis. The RBI’s stance on issuing such permits in the current global economic context is unclear, especially given that these rights will allow non-Indian preferred shareholders to own proportionally larger interests in Indian enterprises (“often to the detriment of promoters and other equity shareholders”). 

Hence, the lack of clarity can lead to injurious seriousness, and according to the words of an expert of legal industry “a comprehensive examination of terms before investing, along with excellent negotiation abilities, can put the ball in one’s court and act as a game-changer should a down-round be undertaken by the company dodging the corporate loop.”

Key takeaways and conclusion 

Any anti-dilution clauses that founders have agreed to should be thoroughly understood. Now, talking about the possibilities to raise capital, founders can assess ‘pay-to-play’ provision, which compels investors to participate in down rounds in order to keep their anti-dilution rights (and possibly, other preferred rights that they hold) Furthermore, early-stage startups seeking funding during similar times should carefully consider the anti-dilution strategies they agree to. 

Anti-dilution rights are heavily negotiated as part of investment transactions. Both founders & investors must understand early-stage startups seeking funding during these periods should carefully consider the anti-dilution mechanisms they sign up for. With a reduction in business valuations resulting from the COVID-19 pandemic’s economic downturn, and corporations obtaining funds at lower valuations, disputes regarding the implementation of these clauses are anticipated to arise.

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