Anti-dilution provisions are contractual clauses that protect shareholders from the dilutive effects of future financing rounds.
There are two primary types of anti-dilution protection: full ratchet and weighted average.
Full Ratchet: In this method, the shareholder’s conversion price is adjusted so that they maintain the same ownership percentage after the issuance of new shares. For example, if an investor initially owns 20% of a company and new shares are issued at a lower price, their conversion price is lowered to the new price, allowing them to maintain their 20% ownership.
Weighted Average: (mostly used) This method adjusts the conversion price based on the weighted average of the share price in the new financing round and the investor's original price. This results in a more moderate dilution protection compared to the full ratchet method.
Example
Initial Situation:
The company has 1,000,000 shares outstanding.
Co-founder A owns 400,000 shares (40% ownership).
Co-founder B owns 400,000 shares (40% ownership).
Investor 1 owns 200,000 shares (20% ownership).
The price per share is $5, resulting in a company valuation of $5,000,000.
Series A Investment Round:
The company raises $10,000,000 in a Series A round.
The pre-money valuation is $30,000,000.
The post-money valuation becomes $40,000,000 ($30,000,000 pre-money + $10,000,000 new investment).
The price per share for the Series A round is $20 ($10,000,000 / 500,000 new shares).
500,000 new shares are issued, making a total of 1,500,000 shares outstanding.
After the Series A investment, the ownership stakes are:
Co-founder A: 400,000 / 1,500,000 = 26.67% (a decrease from the initial 40%).
Co-founder B: 400,000 / 1,500,000 = 26.67% (a decrease from the initial 40%).
Investor 1: 200,000 / 1,500,000 = 13.33% (a decrease from the initial 20%).
Series A Investor: 500,000 / 1,500,000 = 33.33%
Now, let's apply both anti-dilution provisions to the co-founders' shares:
Full Ratchet Anti-Dilution:
Co-founder A's and Co-founder B's price per share is adjusted to the new price of $20.
Both co-founders are entitled to twice as many shares as before, each receiving 800,000 shares to maintain their 40% ownership.
Total shares outstanding become 2,300,000 (1,500,000 original shares + 400,000 new shares for co-founders).
Co-founder A's ownership: 800,000 / 2,300,000 ≈ 34.78%
Co-founder B's ownership: 800,000 / 2,300,000 ≈ 34.78%
Investor 1's ownership: 200,000 / 2,300,000 ≈ 8.70%
Series A Investor's ownership: 500,000 / 2,300,000 ≈ 21.74%
Weighted Average Anti-Dilution:
The weighted average price per share is calculated as:
(Total Pre-Money Value + New Investment) / (Total Pre-Money Shares + New Shares)
($30,000,000 + $10,000,000) / (1,500,000) = $26.67
Co-founder A's and Co-founder B's adjusted shares:
Original Investment / Weighted Average Price per Share
$2,000,000 / $26.67 ≈ 75,000 shares each
Total shares outstanding become 1,650,000 (1,000,000 original shares + 500,000 new shares + 150,000 shares for co-founders).
Co-founder A's ownership: 475,000 / 1,650,000 ≈ 28.79%
Co-founder B's ownership: 475,000 / 1,650,000 ≈ 28.79%
Investor 1's ownership: 200,000 / 1,650,000 ≈ 12.12%
Series A Investor's ownership: 500,000 / 1,650,000 ≈ 30.30%
With the weighted average anti-dilution provision, Co-founder A and Co-founder B maintain a higher percentage of ownership compared to the scenario without any anti-dilution protection, but it's not as high as in the full ratchet example. This method is generally considered more balanced and fair for all parties involved.
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