A Primer on Anti-Dilution


Louis Wharton, Partner with Stubbs Alderton & Markiles, LLP gives a brief primer on anti-dilution protection. Louis’s practice focuses on advising startup, emerging growth and middle market companies across a spectrum of industries in securities compliance, corporate finance, mergers and acquisitions and general corporate matters.

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Prudent investors often request some protection against the risks associated with a decrease in the value of companies in which they invest (referred to herein as the issuer).  Investors typically obtain this protection by including in the issuer’s charter provisions facilitating a reduction, in certain circumstances, of the price at which they will convert the preferred stock they purchase into shares of the issuer’s common stock.  Anti-dilution protection ensures that in the event of a down round (i.e. a subsequent financing in which the issuer sells shares at a price below the price the investor paid) the investor will suffer a more limited amount of dilution (i.e. a smaller reduction in the percentage of the issuer’s stock that the investor owns).

The typical provisions relate to weighted-average anti-dilution protection.  Broad-based weighted-average anti-dilution protection takes into account all securities that are convertible into, exercisable for or exchangeable for shares of the issuer’s common stock.  The typical formula adjusts the conversion price for the issuer’s outstanding preferred stock (i.e. the shares purchased by the investor) by reducing that price by an amount based on the ratio of the number of shares of the issuer’s common stock that would be issued in the down round at the then existing conversion price, compared to the number of shares of the issuer’s common stock that are issued in the down round at the lower offering price.

Narrow-based weighted-average anti-dilution protection takes into account only certain of the securities convertible into shares of the issuer’s common stock.  These typically include outstanding preferred securities, but typically exclude options, warrants and shares issuable pursuant to stock incentive pools or reserves.  Like broad-based weighted-average anti-dilution protection, narrow-based weighted-average anti-dilution protection reduces the then current conversion price by an amount based on the ratio of the number of shares of the issuer’s common stock that would be issued in the down round at the then existing conversion price, compared to the number of shares of the issuer’s common stock that that are issued in the down round at the lower offering price, however, the investor obtains greater protection from dilution (through a lower resulting conversion price) since the shares of the issuer’s common stock that are issued at the lower offering price are more heavily weighted in the calculation.

Less typical is full-ratchet anti-dilution protection, which adjusts the conversion price of the issuer’s outstanding preferred stock to the lower price at which the issuer sells new shares.  This form of anti-dilution protection is rarely granted to investors for typical angel and/or VC investments, but may be negotiated in later transactions when valuations have significantly increased between financing rounds.

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For more information regarding Anti-Dilution Protection or similar inquiries, please contact Louis Wharton at lwharton@stubbsalderton.com  or (818) 444-4509.