Anti-Dilution Adjustment Clause

In This Article

What is the Anti-Dilution Adjustment Clause?

The anti-dilution adjustment clause safeguards current investors by offering shares to current stakeholders before making them publicly available. Companies use this method to protect the ownership rights of existing investors.

When a company issues new stock in the market, the total number of stocks increases, which may cause current investors' ownership to decline.
Equity dilution occurs when new shares are issued, decreasing the percentage ownership of earlier investors. This can sometimes result in a decrease in the value of shares issued previously.
This clause considers the existing shareholders' interests.

When new stock enters the market, the percentage share of the company held by existing holders decreases, lowering the cumulative value of the stock owned; to compensate investors, this clause provides them with stock at a lower price, saving existing investors from losing the value of their stock.

In a nutshell, this serves as a buffet for current investors.

Key Takeaways

An anti-dilution adjustment clause is a provision in a company's financial agreements that protects investors from the dilution of their ownership percentage in the event of future equity issuances.
The primary purpose is to protect investor value by ensuring that early investors maintain their proportional ownership and value despite future funding rounds.
Another purpose is investment appeal, by making the investment more attractive by offering protection against the downside risk of dilution.
It is commonly used in venture capital deals to protect investors in startups and high-growth companies. Also, in private equity investments to safeguard against dilution in subsequent funding rounds.

Anti-Dilution Adjustment Clause in Equity Financing

When a company needs financing, some choose to use a technique termed 'equity financing.' This involves selling shares in the company to raise funds.

There are two issues:

1. The decline in the percentage of stocks held by existing investors.

Consider the following scenario: Investor A owns 40% of WSO's 100 stocks. WSO eventually decides to issue additional stock (say 100 more).

The significance of Investor A's stake was reduced dramatically. Eventually, Investor A will own no more than 20% of WSO's stock.

2. Variation in the value of stock

Consider the following scenario: Investor A bought his stock initially for $100/share. Eventually, the company chose to issue more at $90/share.

This is a loss for Investor A since he would've saved his money had he waited a little longer to buy the stocks of WSO. This will create dissatisfaction among current investors.

To avoid such issues, such a clause exists.

How do you protect shares from dilution? The clause protects shares from dilution. In addition to affecting existing shareholders, dilution damages a company's reputation in the market.

In the absence of the clause, potential investors' stocks could be devalued, causing them to lose interest in the company.
On the other hand, if a company has provisions like the anti-dilution adjustment clause to protect investors' interests, other potential investors may gain confidence in the company.

Types of Anti-Dilution Provisions

There are two types of anti-dilution adjustment clause provisions

Price-based anti-dilution adjustment clause provisions
Contractual anti-dilution adjustment clause provisions

Price-Based Anti-Dilution Adjustment Clause Provisions

Possibly, when a company issues stock in the market, it will issue at a lower price than before. Existing investors may have purchased the stock at a higher price, so their stock value may decrease.

As a result, anti-dilution adjustment clause provisions have been created to protect investors.

1. Full Ratchet and Anti-Dilution Adjustment Clause

A full ratchet provision protects investors by allowing them to use the devalued price to buy more stock of the same company.

The provision must give investors a hold on their percentage of ownership to keep their interest entwined with the business.

2. Example

Investor A purchased 100 shares at $10/share, which cost $1,000. Since the company is issuing new shares at $5/share, the value of Investor A's share will decrease by $500.

This loss of $500 will be compensated by offering Investor A the chance to buy more shares worth $500. By using existing share capital, investors buy more shares when the value of the shares declines.

3. Weighted Average

The weighted average method allows investors to keep the devalued stocks at the weighted average price. Unlike the full ratchet method, this method reduces the value of existing investors' shares but provides a small incentive.

The weighted average formula used is,

New Conversion Price = O x (A + B) / (A + C)

Where,

O: Old conversion price
A: Shares outstanding before the new issue
B: Consideration received with the new issue
C: New shares issued

Example

Assume that 1,000 preferred shares are issued at $5 per share during a first proposition and are convertible at a 1:1 ratio. Next, assume the company issues another 1,000 shares at a new price of $3 per share.

To calculate the new conversion price using the weighted average method, plug the numbers into the formula above.

The new conversion price would be

= $5 * (2,000 + $3,000) / (2,000 + $5,000) = $3.57

Previously, the price per share was $5. Later, it was $3. This means that existing shareholders were losing $2 per share.

As a result, the weighted-average method in the adjustment clause helps restore some of the value of existing investors' stocks.

This allows them to convert their stocks to $3.57 instead of $3.

Contractual Anti-Dilution Adjustment Clause Provisions

When an investor wishes to purchase a company's stock, they may stipulate the percentage of stock held by them, which should not be reduced due to future funding attempts.

A contract exists to bind both the company and the investors legally. Such a contract protects existing investors from dilution.

The following is a brief YouTube video explaining the Anti-Dilution Adjustment Clause:

Importance of the Anti-dilution Adjustment Clause

The various benefits are as follows:

1. Secures investors’ capital

The market is dynamic, and continuous funding is crucial for every business to survive. When investors invest their money into any business, they also expect returns.
To achieve equilibrium with all the factors, an anti-dilution adjustment clause is essential to save investors’ capital.
The various requirements under this clause keep the existing investors interested while attracting new investors.
Such adjustments also control the right to ownership. Therefore, new investors won’t overpower existing investors by buying the same shares at a lesser price.

2. Acts as a layer of protection for the company’s stocks

Incorporating an anti-dilution adjustment clause into the corporate charter encourages companies to obtain better valuations in subsequent financing rounds.

It also serves as an incentive for the company to consistently meet investor-determined milestones such as revenue targets and other growth objectives to increase the value of its stock.

How does the clause mechanism work as ‘The corporate loop’?

According to various pieces of research, this clause is a method companies use to raise more capital from existing investors.

Investors realize that their stake in the company might decrease with the issuance of new shares.

Therefore, they are more likely to buy more stocks offered to them at discounted prices.

When companies need bridge financing or feel the need to negotiate terms with investors, such practice is incorporated.

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