When do I need to think anti-dilution?

If you’ve seen The Social Network, you might vaguely recall the scene in which Eduardo Saverin’s stock is unexpectedly diluted – essentially a passive-aggressive “kick me” sign from the company and investors.

I wish I could have keep track of the number of questions I’ve gotten about anti-dilution before and after that movie came out.

When is it implicated?

Frankly, I don’t remember the underlying mechanism that allowed for diluting Saverin’s stock, but here’s where anti-dilution typically kicks in and is relevant:

  1. Option pools, which I covered in an earlier post.  (VCs will always insist that you create an option pool prior to taking money, because if created afterwards it would immediately dilute their ownership.)
  2. Situations where a startup has at least two rounds of investment, and the second round of investment is done at a lower share price.  That’s called a down round, and means that the startup is doing poorly.

So founders, unless your company is circling the drain after at least two rounds of financing, you probably shouldn’t be concerned.

Definition

Anti-dilution is a provision that goes into stock purchase agreements (among others), and uses a conversion price to determine the number of additional common shares the first investor receives after the second investor’s round.  By increasing the number of shares, the first investor is able to avoid dilution of its ownership, hence the term.

Here’s another way to look at it: the conversion price retroactively adjusts the share price so it’s as if the first investor invested at the lower share price like the second investor did.

Simple example: First Capital owns 1 million preferred shares in Fundco after investing $1 million.  This means the share price is $1.00/share.

Fundco becomes unprofitable, yet convinces Second Capital to invest an additional $1 million, at a share price of $.50/share.

Clearly, this would lead to First Capital’s ownership being heavily diluted.  However, First Capital has an anti-dilution provision with a conversion price of $.50/share.

This means First Capital’s 1 million preferred shares will convert into common shares as if they were bought at $.50/share.  Instead of 1 million preferred shares, First Capital will end up with 2 million common shares.

Other considerations

For the record, there are two general types of anti-dilution provisions, each with their own flavor:

  1. Full ratchet: the first investor’s share price is adjusted all the way down to the second investor’s share price.  This is very investor-friendly, IE gives them more shares.  This was showcased in the example above.
  2. Broad and narrow-based weighted average: the first investor’s share price depends on a formula which considers the amounts invested.  This is typically more founder-friendly.

Also of note is the fact that anti-dilution provisions often affect voting rights drastically, because (1) the converted stock is all common stock, and (2) the preferred stockholder typically votes on an as-converted-to-common basis.

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