Dilution is the norm in every entrepreneur and investor relationship. Let’s face it, no one enjoys dilution. Simply put, it means you have less of something, which is not appealing to anyone. Worse than dilution, is the effects of an Anti-Dilution provision. This is a scenario everyone desparately seeks to avoid.
While you as the entrepreneur need to focus on building value, the reality is every round of funding results in dilution of your percentage ownership in your company. If the value of your company is growing, then you are accepting dilution to support growth. This means while you may own less of the company, your piece of the company is worth more. That’s a good thing.
Unfortunately, not all dilution is good. Sometimes companies miss their targets, and are faced with raising a new round of funding at a value equal or lower than a previous round. This is not a good feeling, and the consequence usually involves one party (the entrepreneur) being heavily punished.
As discussed in the prior piece on Common v Preferred Stock differing classes of shares will be affected in different ways. Dilution & Anti-Dilution is a significant difference.
Anti-Dilution Clauses and Ratchets
Almost every venture financing round will have some form of anti-dilution protection for investors. Investors will seek to protect themselves in the case a future round of funding is for a lower value. While the entrepreneur will approach funders as “partners” many investors consider themselves to be “limited liability partners.” Although an investor may be diluted in the course of future funding rounds unless they continue to invest, they expect this, and are happy to own a smaller percentage of the company understanding that the value of their shares will have increased. Anti-Dilution and Ratchets are designed for the opposite scenario, where the value goes down.
An anti-dilution clause is a provision in a company’s financing agreements that is designed to protect existing preferred shareholders in a company from a reduction in their ownership position. The effects of the dilution protection provisions come into play if the company raises capital in a way that results in a decrease the preferred shareholder’ percentage claim on assets of the company.
Anti-Dilution clauses represent one of the most important provisions in funding agreements and shareholder agreements. If you as the entrepreneur do not understand why they are advanced by investors, and the implications if the provision is triggered, you will be in for a very rude surprise if anything goes amiss during the company’s growth.
Anti-dilution clauses are used to protect investors in the case that a company issues equity at a lower valuation then in previous financing rounds. They do not protect the entrepreneur.
Anti-dilution Provisions
The standard clause means that conversion price of the Series “X” preferred stock will be subject to an adjustment if the company accepts additional funding that does not increase the post-money valuation of the company. Such additional stock shall be issued to investors to ensure they maintain their percentage of ownership in the company.
So how does this work in practice?
I have a company, and it’s worth $3MM pre-money. I receive an investment of $3MM for 50% of the post transaction stock, at $1 / share. I now have $3MM in common shares, and the investor has $3MM in preferred shares. While my ownership stake has been diluted by 50%, the asset value is still $3MM to me.
Six months later, a strategic partner offers to invest $1MM in the company, at the same rate as the previous round. If the offer is accepted, and a full anti-dilution provision on percentage ownership is in place, here’s the outcome: The initial investors still own 50% of the company, the new investor has 16.6% (⅓ of 50%), and the entrepreneur / common shareholders will have 33.3%. Now, the entrepreneur’s share is only worth $2MM, despite $4MM being added to their company. In reality, your asset is really no longer worth $2MM, as you need to account for additional dilution to reserve common shares for an Employee Stock Option Plan (ESOP). This will be covered in a separate article.
However, if it is a good deal for the company, both investors and the entrepreneur will normally accept to be diluted equally, and generally preferred shareholders will waive their anti-dilution rights for this transaction. But you will need to agree to this in writing prior to accepting the investment.
Ratchet Clause
If a ratchet clause is included in the financing agreements, it will come into play if the company issues new shares at a lower price per share to the prior round. In this circumstance, the effective price on all shares is reduced, and the company issues additional shares to compensate investors and maintain their investment. For example, let’s say they invested $3MM into the company, but the new $1MM round of investment only values the company at $4MM. As the entrepreneur, the dilution means you are effectively out as a shareholder.
In a full ratchet, any share transaction for a price lower than the prior series would result in all of the prior series stocks being repriced to the issuance price. This is bad news for everyone, and thus ratchets are usually weighted.
Most investors do not want the entrepreneur and team to depart the company, so even though dilution as a result of a ratchet may be draconian, it is in everyone’s interest to have founders maintain some shareholder equity.
The Educated Entrepreneur
Anti-dilution protection, along with liquidation preferences, are two of the most important features distinguishing preferred shares from common shares in private company financings. We all plan for when things go as expected; Anti-dilution provisions are in place to account for when things go poorly. The educated entrepreneur will plan for both scenarios, and will understand and plan for the full myriad of ways any situation could develop.