Anti-Dilution

Anti-dilution provisions protect preferred shareholders in down rounds by adjusting their conversion price so they receive more common shares for the same invested dollars.

Key Mechanics

• When a new round is priced below the prior round (a down round), anti-dilution clauses reduce the preferred investors’ conversion price.
• This does not create new money; it reallocates ownership from common stockholders (founders, employees) to preferred investors.

Types of Anti-Dilution

1. Full Ratchet
   • Most aggressive form.
   • If an investor originally paid $2/share and the next round is at $1/share, their entire position is repriced as if they had invested at $1.
   • Effectively doubles their share count for the same $2M invested, with no additional cash.
   • Extremely dilutive to common stock and generally considered founder- and employee-unfriendly.
2. Weighted Average
   • More common and less punitive.
   • Adjusts the conversion price based on a formula that blends:
     • the old price,
     • the new lower price, and
     • how many new shares are issued at the lower price.
   • Investors get some extra shares, but not as many as under full ratchet.

Illustrative Example

• Series A: Investor buys 1M preferred shares at $2/share ($2M), owning 20%.
• Later down round at $1/share.
• Full Ratchet:
  • Conversion price resets from $2 to $1.
  • Their $2M is treated as if it bought 2M shares at $1.
  • Ownership rises from 20% to ~33%.
  • The extra ~13% comes out of founders’ and employees’ ownership.
• Weighted Average:
  • Conversion price might drop from $2 to around $1.60 (exact number depends on how much is raised at $1).
  • Their effective share count rises from 1M to ~1.25M.
  • Still dilutive to common, but far less extreme than full ratchet.

Who Is Affected?

• Anti-dilution protections live in the company charter and apply to preferred shares, not directly to employee stock options.
• However, the extra shares granted to preferred investors come from the same overall equity pie, so:
  • Founders and employees experience additional dilution.
  • Multiple down rounds with anti-dilution can severely erode or effectively wipe out employee equity.

What to Watch For as an Employee or Founder

• Full ratchet provisions
  • Red flag; can destroy common stockholder value in a single bad round.
  • Ask counsel to review the charter for any full ratchet language.
• Multiple down rounds
  • One down round with weighted average is often survivable.
  • Two or three down rounds, especially with strong anti-dilution, can leave common holders with very little.
• No anti-dilution at all
  • Surprisingly positive for employees and founders.
  • Means investors share dilution risk more equally with common stockholders.

Related Concepts

• Dilution – Overall reduction in ownership percentage as new shares are issued.
• Preferred Shares – Investor-favored stock class that typically includes anti-dilution rights.
• Down round – A financing at a lower valuation than the previous round, which is what triggers anti-dilution protections.