An investor may require a startup to include an anti-dilution clause in the shareholders agreement when looking to raise capital in exchange for equity. It’s important that startups understand the effect of anti-dilution clauses on both future capital raising and the founder’s interests more generally.

What is an Anti-Dilution Clause?

Although anti-dilution clauses can apply to ordinary shares, they more typically attach to preference shares. The anti-dilution clause serves to protect the shareholder from a dilution in their shareholding if the startup chooses to issue future equity – such as when a second or third round is raised.

Dilution occurs when a shareholder’s stake in a company decreases as a result of an increase in the number of shares in the company. Anti-dilution clauses are aimed at protecting investors from dilution where new shares are issued at a price less than that paid by those initial investors.

There are two main forms of anti-dilution clauses that an investor may insist that the agreement includes are: 

  1. Full ratchet; and 
  2. Weighted Average Ratchet.

Full Ratchet

The full ratchet anti-dilution clause provides the greatest protection for investors, but it is the most restrictive for companies who wish to have multiple fundraising rounds.

When a shareholder converts their preference shares to ordinary shares, the conversion price of their preference shares is reduced to reflect the share issuance price for the next round. This means that shareholders can convert their preference shares at the new, lower price.

Similarly, if the shareholder holds ordinary shares, then additional shares will be issued immediately after the new round. In both circumstances, the shareholder will receive more shares for their initial investment to ensure that their stake in the company is not diluted.

Weighted Average Ratchet

The weighted average ratchet dilution adjustment is the standard anti-dilution protection included for investors. Under a weighted average ratchet anti-dilution clause, the shareholders will be able to increase their shareholding at a weighted average of the new share issuance price.

A formula in the agreement governs this weighted average which calculates the weighted average share price based on: 

  • The amount the company raised before the additional round; and
  • The average price per share compared with the subsequent capital raise and lower share price.

While the weighted average formula will not completely protect the investors from dilution, it can significantly lessen the effect, and it is the more company-friendly of the two types of anti-dilution clauses.

What is the Effect for the Company and Founders?

Importantly for both founders and shareholders, not everyone may be subject to an anti-dilution clause. Parties negotiate an anti-dilution clause into existence in particular circumstances. This means that anti-dilution clauses may protect one investor at the expense of another who is not similarly protected. The anti-dilution clause will exacerbate the effect of dilution on an unprotected shareholder by increasing the shareholder of the protected investors.

This is especially troubling when the unprotected shareholder is a founder or key person in the business. Overly diluting their shareholding may remove their incentive to play an active role in the business and facilitate its growth. 

Smart investors will not want to de-incentivise founders from growing the business. However, when a number of investors are involved, with multiple rounds raised, the effect of anti-dilution clauses can create significantly impact the business’ performance.

Is There a Better Way?

If your business desperately needs a capital injection, you may not be able to refuse an investor who is insisting on an anti-dilution clause. Given the limitations that an anti-dilution clause can impose on future fundraising and the existing shareholders, you may wish to consider negotiating the anti-dilution clause as a ‘Pay to Play’ provision.

A startup lawyer can draft a Pay to Play provision so that investors are only protected from dilution if they participate in subsequent rounds of capital raising. This incentivises investors to keep contributing to the company and can apply to both full ratchet and weighted average ratchet clauses. This is a way to satisfy both the interests of investors in protecting their initial stake and the interests of a startup raising additional capital in a less onerous way.

Key Takeaways

Including anti-dilution clauses in agreements with investors is not typically in the company’s best interests. However, when a company is in desperate need for capital, it may be the only choice. If an investor is insisting on including such provisions, you should strongly weigh its effects against the need for the investor’s involvement. A Pay to Play clause could lessen the effect of the provision on future fundraising.

If you have any questions about anti-dilution clauses or need assistance with drafting your startup’s shareholders agreement, get in touch on 1300 544 755.

Madeleine Hunt
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