In this post, we will attempt to understand what dilution is, how it works and what anti-dilution measures can be taken. As an entrepreneur, understanding the concept of dilution is very important in helping you raise capital for your business.
What is dilution?
Dilution is a reduction in the percentage ownership of a given shareholder in a company caused by the issuance of new shares. Dilution is good if the company manages to profit out of issuing new shares, but if the company fails to make a profit, then the dilution will reduce the value of your holdings. Dilution can be likened to the act of dividing the proverbial pie into ever smaller pieces.
How does dilution work?
Here is a simple explanation of how dilution works:
What are anti-dilution provisions?
Dilution protection provisions are provisions that protect the investment of a particular investor. These are used to calculated the conversion ratio of an investor’s shares. Often, an investor will put money into a company and buy preferred share rather than common shares and the preferred shares will convert at a certain ratio to common shares. [Note:You don’t need to have this only apply to preference shares. You can do this with common share but the mechanism of it is a little more complex than with a two share structure and a conversion ratio.]
The dilution protection provisions will kick in to alter the ratio of that conversion ratio. Dilution protection is often done in two ways – full ratchet and weighted average. These anti-dilution provisions may be negotiated by investors to protect the value of their investment from future rounds of dilution. These can also be used by some but not all shareholders. (If all shareholders have anti-dilution provisions, new investors will by definition get zero shares.)
Weighted Average: This calculates the price of shares considering the price and the amount of money previously raised as well as the price and amount of money being raised in the subsequent dilutive financing.
This calculation often uses one of two formulae basically differentiated by what constitutes “issued and outstanding common stock”. These are broad based and narrow based.
1) Broad based: the term “issued and outstanding common stock” includes all shares of stock outstanding, common and future stocks. Founders and existing shareholders may want to use this formula for new investors. This anti-dilution clause is more “company friendly” and also the most customisable one because many investors agree to this.
2) Narrow based: the term “issued and outstanding common stock” includes only the common stock issuable upon conversion. Narrow based is the most beneficial for investors since this formula provides a higher conversion rate than the broad based.
In essence the weighted average gives investors a conversion price that is between the old valuation of the shares (when they came in) and the newer valuation of the shares (when the next round comes in) but also accounts for the number of new shares being issued, i.e. some relief for existing shareholders.
Full Ratchet: Full ratchet anti-dilution protection for new investors is simpler than the weighted average approach, and its effect on the founders/existing shareholders is considerably more severe in the event of a dilutive financing. Under the full ratchet formula, the conversion price of the preferred stock outstanding prior to such financing is reduced to a price equal to the price per share paid in the dilutive financing.
- For Existing Shareholders: not preferable as it seriously jeopardizes their ability to raise money from the next round of investors.
- For Investors: it is generally very beneficial to have but then company may get locked down to those investors and it may not be in the long term interests of either the investors or the company.
As my mentor used to say, no one died of dilution. It’s a fact of a company’s existence as it grows and takes in additional equity investment (as opposed to debt.) Any use of anti-dilution provisions by any shareholder will, naturally, be resisted by incoming investors. The questions for you as a shareholder or investor (assuming no full ratchet anti-dilution) are:
a) whether the pie will grow large enough to compensate for your reduced percentage in the next round, b) which of the shareholders will bear the burden, c) what will the percentage of dilution.
Please do not hesitate to contact us with any questions or comments.
Please note that the information on this blog post or in any other part of this site does not constitute legal advice to you for your specific circumstances. For actual legal advice, please be in touch and we will attempt to assist you or refer you to the appropriate advisor.