Concept and Carve outs

This is a standard clause in a term sheet and it is best for the entrepreneur to minimise its impact in creative ways than argue to do away with it entirely. The term essentially denotes that when a company receives a second round of funding at a price per share that is lesser than the price the shares fetched in the first round of funding, the first round investors by exercise of the anti-dilution clause are protected from the resultant stock dilution.

There are certain exclusions to the applicability of the anti-dilution clause and these are usually referred to as ‘Anti Dilution Carve Outs’. These are (i) employee stock options (ESOPs) (ii) shares issued for consideration other than cash and this usually happens in scenarios of merger, amalgamation, acquisition, consolidation etc and (iii) shares with respect to which the holders of a majority of the outstanding Series A investors waive their anti-dilution rights. Thus, in a down round (where the valuation of the company is lower than the valuation it received in a previous round) the anti-dilution rights do not normally kick in with respect to (i) to (iii).

Who gets what?

Investors usually invest in a company with the hope that successive valuations will be higher and the return they can promise in turn to their investors will successively be an increase. However, market conditions may result in significant valuation swings in different market cycles and the anti-dilution is a material provision that investors seek for protection and is usually considered an automatic right. Promoters should not be averse to this provision and may do well to remember that if not for this clause they may have never got funded in the first place.

In fact, the anti-dilution clause encourages the company to seek higher valuations at all times and incentivises the company to better perform towards this end. Though rare, it is not unheard of for anti-dilution clauses to be linked to milestone based performances. In these cases, the clause will kick in automatically, but, is avoided by management so as to not incentivise the company to be focused only on milestones at the cost of strategic development in tandem with market cycles.

Introduction in a term sheet

Anti-dilution clauses always appear in a term sheet except, perhaps, in a Series A round. However, since investors are always hung up about having the exact terms as previous investors in addition to their own terms and some more from their lawyers, this has begun showing up in Series A term sheets. And the Series A investors know exactly that Series B and further round investors will request such a clause by default.

It is also a protection clause at Series A itself. Say price per share in A round is at Rs. 10, B round is at Rs. 20 and C round is at Rs. 15. If B exercises the anti-dilution clause it gains at the expense of A and this is why the promoters now often see the clause in series A itself.

Types of anti-dilution

Full-ratchet anti-dilution protection gives the original investor rights to that number of shares of common stock as if he paid the current round’s lower price. The language that is used in a term sheet to say this is: “In the event that the Company issues additional securities in the future at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be adjusted in accordance with the following formula.” National Venture Capital Association defines full-ratchet as – the conversion price will be reduced to the price at which the new shares are issued.

Weighted Average anti-dilution protection gives consideration to the relationship between the total shares outstanding as compared to the shares held by the original investor. The legal language that is used in a term sheet to say this is: “In the event that the Company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be adjusted in accordance with the following formula: CP2 = CP1 * (A+B) / (A+C), where:

CP2 – new conversion price ; CP1 – old conversion price ; A – common stock outstanding

B – “what the buyer should have bought if it had not been a ‘down round’ issuance” (common stock purchasable with consideration received by company)

C – “what the buyer actually bought” (common stock actually purchased in subsequent issuance)

In this manner a “new conversion price” for the Series A is determined. Sometimes anti- dilution clause is also called Conversion Price Adjustment.

Thus, in the full-ratchet mode if the company sold one share at a price lower than the Series A, all of the Series A shares will be re-priced at the new issue price. In the weighted average mode, the number of shares issued at the reduced price is considered in the re-pricing of the Series A.

I believe the most common form of anti-dilution provision and the one that causes least damage to founders is the weighted average anti dilution clause. A key take away from this discussion is surely to use a banker for the calculations and a lawyer to negotiate this clause for you. The issue also gets more complex when there are stock splits, dividends, option pools and fully diluted basis of conversion considered. Do not try to negotiate this clause away, but, take it as a given and negotiate in a manner to impose restrictions when the applicability of the clause wears off.