What is an 'Anti-Dilution Provision'

An anti-dilution provision is a provision in an option or a convertible security, and it is also known as an "anti-dilution clause." It protects an investor from equity dilution resulting from later issues of stock at a lower price than the investor originally paid. These are common with convertible preferred stock, which is a favored form of venture capital investment.

BREAKING DOWN 'Anti-Dilution Provision'

An anti-dilution provision protects investors from the dilution of an equity position – something that occurs when an owner's percentage stake in a company decreases because of an increase in the total number of shares outstanding. Total shares outstanding may increase because of new shares being issued due to a round of equity financing or perhaps because existing option owners exercise their options. Sometimes, the company receives enough cash in exchange for the shares that the increase in value of the shares offsets the effects of dilution. Often, this is not the case.

Anti-Dilution Example

In venture capital investing in particular, dilution is a concern for preferred shareholders, as a later issue of stock at a price lower than their current shares would dilute their total ownership. Anti-dilution clauses prevent this from occurring by adjusting the conversion price between preferred stock and common stock. These clauses are also known as preemptive rights, subscription privileges or subscription rights.

As a simple example of dilution, assume that an investor owns 200,000 shares of a company which has 1,000,000 shares outstanding. The price per share is $5, meaning that the investor has a $1,000,000 stake in a company valued at $5,000,000. The investor owns 20% of the company. Next, assume that the company enters a new round of financing and issues 1,000,000 more shares, bringing the total shares outstanding to 2,000,000. Now, at that same $5 per share price, the investor owns a $1,000,000 stake in a $10,000,000 company. Instantly, the investors ownership has been diluted to 10%.

Anti-dilution clauses prevent this from happening, keeping the investor's original ownership percentage in tact. The two common types of anti-dilution clauses are known as "full ratchet" and "weighted average." With a full ratchet provision, the conversion price of the existing preferred shares is adjusted downwards to the price at which new shares are issued in later rounds. Very simply, if the original conversion price was $5 and in a later round the conversion price is $2.50, the investor's original conversion price would adjust to $2.50.

The weighted average provision uses the following formula to determine new conversion prices, C2 = C1 x (A + B) / (A + C), where the variables equal the following:

C2 = new conversion price

C1 = old conversion price

A = number of outstanding shares before new issue

B = total consideration received by the company for the new issue

C = number of new shares issued

RELATED TERMS
  1. Dilution Protection

    Dilution protection is a provision that seeks to protect shareholders ...
  2. Antidilutive

    Antidilutive describes any type of action that maintains or increases ...
  3. Fully Diluted Shares

    Fully diluted shares is the total number of shares that would ...
  4. Adjustment in Conversion Terms

    A term used to describe the adjustment made to a convertible ...
  5. Diluted Earnings Per Share - Diluted ...

    Diluted EPS is a performance metric used to assess a company's ...
  6. Diluted Normalized Earnings Per ...

    Diluted Normalized Earnings Per Share measures a company's earnings ...
Related Articles
  1. Investing

    The Dangers of Share Dilution

    Investors need to be aware of dilutive securities and how they can affect existing shareholders.
  2. Investing

    Investment Valuation Ratios

    Learn about per share data, price/book value ratio, price/cash flow ratio, price/earnings ratio, price/sales ratio, dividend yield and the enterprise multiple.
  3. Investing

    How to pick winning penny stocks

    When choosing penny stocks, wise investors note several key factors that affect the way these stocks trade – and the inherent risks that can follow.
  4. Investing

    Introduction to Convertible Preferred Shares

    These securities offer an answer for investors who want the profit potential of stocks but not the risk.
  5. Investing

    The Basics Of Outstanding Shares And The Float

    We go over different types of shares and what investors need to know about them.
  6. Investing

    Convertible bonds: pros and cons for companies and investors

    Understand what effect convertible bonds have on investors and companies. Find out the advantages, disadvantages, and what the issue means from a corporate standpoint before buying in.
  7. Investing

    Tesla's Bond Issue Is 'Imprudent': NYU Prof.

    The decision by cutting-edge car maker Tesla to finance itself heavily with debt is "puzzling and troubling," an NYU finance professor says.
  8. Managing Wealth

    Issued share capital versus subscribed share capital

    Learn the difference between issued share capital versus subscribed share capital. Get information about various types of capital.
RELATED FAQS
  1. The share price and company's secondary offering

    When a company increases the number of shares issued through a secondary offering, it generally has a negative effect on ... Read Answer >>
  2. What Does the Diluted Share Price Reveal?

    Learn how diluted share price affects earnings and the company's overall financial performance. Read Answer >>
  3. Weighted Average Shares Vs. Outstanding Shares

    What's the difference between weighted average shares outstanding and basic weighted average shares? Read Answer >>
  4. Why is an increase in capital stock on a company's balance sheet a bad sign for stockholders?

    Understand what capital stock represents for a company and understand the significance for investors when a company initiates ... Read Answer >>
  5. What Is an Evergreen Provision?

    An evergreen provision grants equity allotments to certain employees on a regular basis. Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center