When the parties in a venture capital investment are only a hair’s breadth away from signing the investment agreement, it is worth laying a solid foundation for company building with an anti-dilution protection clause. After all, a glass of fine wine may still be enjoyable when diluted, but in the world of investments, dilution is best avoided.
Dilution occurs when a new investor enters the company in a new funding round at a lower valuation than the investor or investors from previous rounds. It is easy to see why this is disadvantageous for the original investors, as the first-round investor paid more for the same shareholding than the new investor.
Anti-dilution protection is designed to avoid such situations. Its purpose is to ensure that the new investor cannot acquire an identical or larger shareholding in the company on more favourable financial terms than previous investors. If this nevertheless happens, previous investors may be entitled to compensation based on the protection clause. Typically, in such cases, the company’s founders are required to top up the previous investor from their own shareholding so that the investor’s original ownership percentage is maintained. As a result, the first-round investor will effectively hold its shareholding at the same valuation as the price offered to the next-round investor in the new capital increase.
One purpose of anti-dilution provisions is to encourage the company and its founders to ensure that the issue value of newly issued shares is higher, allowing the company to raise a larger investment amount more easily. On the other hand, there are also solutions where investors link these provisions to milestones set for the company, thereby creating strong incentives for the company to meet certain revenue or other business targets, so that the company can generate the necessary capital itself and avoid the need for a new investor to enter.
In practice, anti-dilution protection works by the company repricing the value of its shares and reallocating them among the members, primarily by reducing the founders’ shareholding. There are several established calculation methods for this, of which we now present the two most popular ones.
Weighted average formula
This calculation method is based on the share values arising in the new investment and the previous investment, and the previous investor’s new ownership percentage is determined from their weighted average. Although the previous investor is diluted in this case, the dilution is significantly smaller than it would have been without anti-dilution protection. There are two main versions of this formula. One is the broad-based method, where the calculation is based on all issued and issuable shares. The other is the narrow-based method, where only the outstanding shares are taken into account.
Full-ratchet formula
Under this method, the previous investor’s shareholding is topped up to the level it would have had if the investor had entered the company together with the new investor during the new capital increase. Accordingly, the company issues such a number of new shares to the previous investor that the value of its investment remains unchanged. This means that, in this case, the previous investor is not affected by dilution at all.
As we can see, the two calculation methods lead to completely different consequences. Although the full-ratchet formula is the best choice for the previous investor, the founders’ shareholding may be reduced almost to a minimum in this case, as a result of which they may lose control rights in the company. Therefore, in order to find the golden mean, it may be more advisable to choose the broad-based weighted average formula, as it may provide a more favourable outcome for the founders.