What Is an Anti-Dilution Provision?
Anti-dilution provisions--sometimes referred to as "anti-dilution clauses", are measures built into a convertible security or an option, that shield investors from the equity dilution that can occur when later issues of the stock hit the market at cheaper prices than those investors earlier paid. Such provisions are typically associated with convertible preferred stocks.
Understanding 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 the value of the shares offsets the effects of dilution. Often, this is not the case.
- An anti-dilution provision is a provision in an option or a convertible security that protects an investor from equity dilution, resulting from later issues of stock at a lower price than the investor originally paid.
- Anti-dilution provisions are common with convertible preferred stock, a favored form of venture capital investment.
- Anti-dilution provisions are also known as preemptive rights, subscription privileges, or subscription rights.
Dilution can be particularly vexing to preferred shareholders of venture capital deals, whose stock ownership may become diluted when later issues of cheaper stock shares are rolled out. Anti-dilution clauses, which are alternatively dubbed "preemptive rights", subscription privileges", or "subscription rights", discourage this activity from happening by tweaking the conversion price between common stock and preferred stock.
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 intact. 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 a new issue
B = total consideration received by the company for the new issue
C = number of new shares issued