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Anti-dilution protection is a provision in the investment agreement that safeguards an investor’s ownership percentage in a company in the event that the company issues more shares at a lower price than the investor originally paid (as in a down round). This protection is typically a feature of preferred stock and is designed to prevent significant dilution of an investor’s equity stake and, by extension, their voting power and share of future profits.

There are two primary types of anti-dilution protection:

  1. Full Ratchet: With full ratchet anti-dilution protection, if a company issues new shares at a price lower than what the previous investor paid, the conversion price of the previous investor’s preferred shares is adjusted downward to the price of the new shares. This means that the investor’s preferred shares are now convertible into a greater number of common shares, ensuring that their percentage ownership remains the same as it was before the down round. Full ratchet is considered very investor-friendly but can be quite punitive to the founders and other shareholders because it can lead to substantial dilution for them.
  2. Weighted Average: This method is less punitive to existing shareholders than the full ratchet. There are two variations of weighted average anti-dilution protection: broad-based and narrow-based. Both types adjust the conversion price of the existing preferred shares, but they take into account the number of shares outstanding and possibly the number of shares being offered in the down round. The broad-based weighted average includes all common stock equivalents in the calculation (such as all preferred shares, options, and warrants), whereas the narrow-based weighted average includes only a subset (often just the preferred shares). The adjustment is typically less severe than under a full ratchet provision.

Implications of Anti-dilution Provisions:

  • Founder Dilution: Founders and other common stockholders are usually the ones who get diluted when these provisions are triggered, as the anti-dilution adjustments are often made at their expense.
  • Incentive Alignment: From an investor’s perspective, anti-dilution provisions can align incentives by ensuring that founders and management are motivated to avoid down rounds.
  • Investor Confidence: Such provisions can encourage investment by reducing the risk associated with future down rounds.
  • Negotiation of Terms: Anti-dilution terms are often a point of negotiation, with investors seeking to minimize their risk and founders trying to prevent excessive dilution in future financings.

In negotiating anti-dilution provisions, it’s crucial for the company’s founders and management to understand the long-term implications of these provisions and to strike a balance that protects investors without unduly penalizing the existing equity holders.