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If you run a startup and are looking for investors, you may come across investors who require you to include an anti-dilution clause in the shareholders agreement. However, anti-dilution clauses may disadvantage your startup when looking to raise capital in the future. Therefore, it is important that you understand the effect of anti-dilution clauses. This article will explain what an anti-dilution clause is and how one might affect your capital raising process.

What is an Anti-Dilution Clause?

An anti-dilution clause serves to protect the shareholder from a dilution in their shareholding. 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. This may be when a second or third round of capital raising occurs. Anti-dilution clauses aim to protect investors from dilution where new shares are issued at a price less than what they initially paid.

Although anti-dilution clauses can apply to ordinary shares, they more typically attach to preference shares. There are two main forms of anti-dilution clauses that an investor may insist that the agreement includes:

  1. full ratchet; or
  2. weighted average ratchet.

Full Ratchet Anti-Dilution Clause

A full ratchet anti-dilution clause provides the greatest protection for investors. However, it is the most restrictive if you 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, the 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 does not experience dilution.

Weighted Average Ratchet Anti-Dilution Clause

The weighted average ratchet dilution adjustment is the standard anti-dilution protection 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 you have raised before the additional round; and
  • 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. Furthermore, it is the more company-friendly of the two types of anti-dilution clauses.

How Does it Affect Your Company?

Importantly, not everyone will be subject to an anti-dilution clause. Parties will only negotiate the existence of an anti-dilution clause in particular circumstances. This means that anti-dilution clauses may protect one investor at the expense of another who is not similarly protected. This is especially troubling when the unprotected shareholder is a founder or key person in the business. Therefore, 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 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. An anti-dilution clause can impose limitations on both your future fundraising and the existing shareholders. Therefore, you may wish to consider negotiating the anti-dilution clause as a ‘Pay to Play’ provision.

You 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. It can also apply to both full ratchet and weighted average ratchet clauses. This method can satisfy both the interests of investors in protecting their initial stake and your interests of additional capital in a less onerous way.

Key Takeaways

Including anti-dilution clauses in your agreements with investors will not, typically, be in your best interests. However, if you’re in desperate need for capital, it may be a choice you have to make. 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 with LegalVision’s capital raising lawyers on 1300 544 755 or fill out the form on this page.


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