PIPE transactions
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This article is written by Sivagnana Selvi who is pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.

What is Anti-dilution Adjustment Clause?

The term anti-dilution is contained in many investment transactions. The term anti-dilution clause is very important for a start-up or for an early-stage company, it is very essential to understand the nitty-gritty of provisions contained in Share Holder Agreements (SHA). Generally, the founder would agree with the standard terms in SHA because they would be in great need of investment. So, this should not take it for granted because harsh provisions could be imposed on the founders, so the anti-dilution clause should be regularly reviewed. The anti-dilution clause is a provision that would be contained in a security agreement or mergers and acquisition agreement. The anti-dilution provision helps the present investors to have the right to maintain their ownership percentage of the company by virtue of purchasing a proportionate number of new shares at a future date when the securities are issues.  

What is Anti-dilution Protection?

For a better understanding of anti-dilution, the concept of ‘dilution’ must be well understood. Dilution means a decrease in shareholder’s shareholding percentage in a company due to incoming shares by subsequent rounds of funding. In other words, decrease in shareholder’s share percentage due to an increase in outstanding shares. For example, a company ABC has 1,000 outstanding shares, out of which X holds 250 shares. That is the investor holds 25% of the company’s shares. By the way of second round of financing, the ABC company issues further 1,000 shares for subscription for the new investors for raising capital.

This, in turn, reduces the stake of X to 12.5% but the number of outstanding shares would be increased to 2,000 shares. In case the new shares are issued at a much lower cost than the present investors first paid, the value of the original investor would be decreased. There might be situations where the company may not perform well subsequently the share value might be reduced. Now the anti-dilution comes to rescue the existing investors, which helps the existing investors to hold their share percentage in the company to a certain level.

The anti-dilution protection is given to the current investors of the company when the company issues new shares after a subsequent round of investment at a rate lower than the price paid by the current investors. It is important to note that the anti-dilution protection is given only when the share price is given lesser than the price paid by the current investors. The rationale behind not giving anti-dilution protection to the share price higher than the price paid by the current investor is the value of the shares held by the investors would increase even though there is a reduction in shareholding percentage. 

What are the types of Anti-dilution protection? 

There are two types of anti-dilution protections available in India for investors 

  1. Price based anti-dilution provision
  • Full Ratchet.
  • Broad-based Weighted Average.

2. Contractual anti-dilution adjustment 

Now let us discuss the various protections in detail:

Price based anti-dilution provision

If a company issues new shares for public subscription, the issuance might dilute the value of the shares held by the existing shareholders. The price-based anti-dilution protects the investors from lower price shares issued by the company in the subsequent rounds. If an investor enjoys price-based dilution protection, the charter of the company would have a conversion formula for converting preferred stocks into common stocks. The price-based anti-dilution can occur in the following forms:

  • Full Ratchet Clause:

The full ratchet is actually very harsh on the company but beneficial to the current investors. According to the National Venture Capital Association defines it as “the conversion price would be decreased to the price at which the new shares are issued” Under this concept, in the subsequent round of investment, if the shares are issued than the price paid by the current investors of the company, then the price of the shares of the current investors would be revised to the price at which the new shares have been issued. 

In this situation, the company either gives additional shares to the current investors for additional consideration, after price adjustment without the current investors paying further payment or the conversion price will be revised to the process of the shares issued. So, in this full ratchet method, it would consider the number of shares held by the current shareholders nor the number of shares issued under the subsequent round of funding. It is confined only to the price of the newly issued shares, so the new price would be applied to all the shares held by the current investors. So, this full ratchet clause is harsh on both the company and the founders of the company than the broad-based weighted average method. 

For example, if an investor has paid a price of Rs. 100 per share at the time of investment and the subsequent shares were issued at the rate of Rs. 80 to the new shareholders, now according to full ratchet protection, the company should make an adjustment for the Rs.20 in favour of the existing shareholder either giving him bonus shares or giving him monetary compensation.  

There is another caveat to this method, the shareholdings of the founders would be diluted largely if the full ratchet method id applied. The disadvantage of the clause is, it would deter new investors from investing in the company. The company would not be the best option to invest in the eyes of the new investor because the clause protects only the current shareholder but it gives burden of dilution to the new shareholders. But, the risk is not great as its sound the new investor would not suffer any actual loss, but they would not be receiving any benefits that the original investors receive. There is an option called partial ratchets, half ratchets or two-third ratches instead of full ratchet, which is less -harsher but very rarely applied.   

  • Broad-Based Weighted Average:

When compared to full ratchet protection, this method uses formula which focuses on the number of shares held by the current shareholders and number of shares issued in the subsequent round of investment, instead of focusing only on the price of the shares held. Since this method is beneficial to both investors and the company, it has been adopted frequently in many investment transactions. 

This method calculates the weighted average price, which is determined by taking into account conversion or existing price of the share, no. of outstanding shares before the issuance of new shares. Therefore, in full ratchet method if a company sells a share price lower than Series A, all the shares of Series A will be re-priced according to the new issue price. But in the weighted average method, the number of shares issued at a lower price is considered in the re-pricing of the Series A investment. 

This method gives a formula that accurately reflects on dilutive effects of new share issuance. Under the broad-based weighted average formula, it focuses on completely diluted capital of the company to reduce the impact of dilution of the common shareholders. The fully diluted capital will consider the conversion of all the convertible securities like stock options, preferred stocks, warrants etc. There is another concept called narrow-based weighted average which focuses only on outstanding shares of the stock and it would exclude the convertible securities. 

Contractual anti-dilution adjustment 

In contractual anti-dilution adjustment, there is an agreement between the current investors and the company, where the company gives consent to issue further shares of the common stock to the investors as to maintain their ownership percentage in the company till the company raises the required capital. It would protect the shareholders from the effects of dilution of their ownership stake from the new share issuance in future. The agreement is entered without considering the price at which new issues of shares sold. 

What is the importance of Anti-dilution adjustment clause?

  • Protects investor equity

Every investor hopes that the value of their portfolio would increase, but due to market conditions, their hopes might be shattered. This would put their ownership at stake. In such a situation, the anti-dilution provision would come for the rescue. It protects the investors from market insecurities and even when the companies borrow more funds at a reduced cost it will guard the initial investors. 

  • Protects the company 

The anti-dilution clauses would protect the initial investors and at the same time, the company shall issue new shares at the price lower than the previous rounds of funding. This would enable them to perform better and increase the capital for expansion.

Conclusion 

India has attracted many foreign investments and it is considered as on of the famous destination for investments. However, investment is always subject to market conditions and risks, it can be minimized by drafting appropriate investment clauses in the investment agreement. The companies should focus on value building after financing so the anti-dilution agreement would doesn’t come into the picture. 


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