Rough Justice or Fair Cop? The Reality of Anti-dilution Provisions

Struan Penwarden, Hale and Dorr (London)

The following article was previously published in Full Ratchetâ„¢, the Trans-Atlantic Venture Capital Review, which is published by Hale and Dorr. If you would like to receive future issues of Full Ratchet, please send an e-mail to

"We need protection against dilution if you engage in future down rounds," said venture capitalists three years ago, not really believing that they would need to call upon this protection. However, the unexpected and significant decline in valuations for companies over recent years has focused the attention of VCs and VC-backed companies on anti-dilution provisions. In today's investment climate, VCs are not only more selective with their potential investments, but are also demanding more favourable financial and control provisions in term sheets. In particular, protection against downside risk is of much more significant importance.

Companies seeking capital may accept VC requirements for anti-dilution protection without understanding the full implications of what they are giving. VCs often refer to "standard" anti-dilution provision as if an agreed standard exists. Although there are some general models, anti-dilution provisions are highly negotiable and therefore require an understanding of the components of the protection afforded to both parties.

Protecting Downside Risk

Anti-dilution provisions serve one fundamental purpose: they protect existing VCs from the adverse impact experienced when a company issues new securities (which can include preference shares, ordinary shares and/or options) at a lower price than that paid by the existing VCs. Anti-dilution protection comes in two principal varieties: full ratchet and weighted average formulas. In each case, the anti-dilution protection is implemented either by an adjustment to the conversion ratio of the VCs' preference shares into ordinary shares or by the issue of additional shares to the VCs.

Full ratchet formulas are the most aggressive form of anti-dilution provision and provide the most protection to VCs but have the greatest negative impact on companies. The mechanics of a full ratchet provision are quite simple, in that the VC will be entitled to be placed in the position (i.e. by reference to the number of preference shares held or number of ordinary shares into which the preference shares will convert) it would have been in had it originally invested in the company at the lower price per share being offered on a subsequent issue.

To entrepreneurs, the full ratchet formula may appear inequitable because it fails to take into account the number of new shares actually issued by the company in a down round or other shares issued at a price less than that paid by the existing VC. Weighted average formulas, on the other hand, by taking into account the number of shares (sometimes including other convertible securities, such as options) already in issue plus the number of new shares being issued at the lower price, can be viewed as more equitable. These types of formulae have the effect of determining the adjustment to be made to an existing VC's shareholding based on an average of the price the VC paid for its shares and the lower price at which the new shares are to be issued. There are different variations of the weighted average formula, but these may be essentially categorised as either broad- or narrow-based. Broad-based weighted average includes a wider range of shares and other securities in the calculation and therefore the adjustment required to the VC's shareholding is less. Therefore, it is less onerous on the company and not as dilutive on the shareholdings of management and the founders.

Pre-Emption Protection v. Anti-dilution Protection

Anti-dilution provisions are commonly confused with pre-emptive rights. A pre-emptive right (either a right of first offer or a right of first refusal) enables an existing investor to purchase a proportion of any subsequent issue or sale of securities so as to ultimately retain or increase their percentage shareholding in the company. A pre-emptive right will be triggered regardless of whether the subsequent issue is for greater or less than the amount paid by the existing VC for their shares. Anti-dilution provisions protect a VC without requiring the VC to pay more (although see pay-to play provisions discussed below), whereas a pre-emptive right requires the existing VC to purchase additional shares to get the benefit of its protection. Accordingly, the VC may receive more protection from a pre-emptive right because it ensures the VC maintains a specific percentage ownership following each issue of shares. However, this benefit is mitigated by the fact that the VC must invest additional money in the company.

Full Ratchet or Weighted Average?

The negotiation of which anti-dilution formula to use can be contentious. A fall in a company's valuation may be caused by a combination of many factors and not just a fall in the general market.

For example, the company may have not reached certain performance milestones that were set on the last funding round and now has to revise its business plan. When negotiating anti-dilution protection, VCs may take the view that they are investing at the agreed price per share on the basis that the business plan (and any milestones therein) will be realised and result in an increased valuation of the company (and of their investment). Accordingly, the VC will want to be protected against any downside in the event that this does not occur. To a VC, a full ratchet adjustment is often seen as the appropriate protection in that the dilutive nature of a fundraising at a lower valuation should be borne by the founders and the management team effecting the business plan and not the VC.

However, from an entrepreneur's perspective, this may seem unfair. The VCs will have been shareholders of the company during the period of decline in valuation and are also likely to have been represented on the board of directors. VCs not only bring money to their portfolio companies but also can add value through their experience and industry expertise. Accordingly, entrepreneurs may feel that the impact of a drop in valuation in the company should be shared among the VCs, management and founders, and therefore a weighted average anti-dilution adjustment is more appropriate.

Full Ratchet Anti-dilution in Practice

There are a number of European VCs who insist on full ratchet anti-dilution as a matter of course. However, to date, a number of these VCs have not fully invoked this protection - even in a down round - because it would have disastrous effect on the company and its management team. Some VC-backed companies that had agreed to full ratchet anti-dilution protection on their last funding round are finding that, due to the tremendous decline in their valuations, the effect is that VCs may be entitled to millions of additional shares, essentially wiping out the ownership stake of the founders and management. Clearly, this not only disincentivises management but also any potential new investors. In such a scenario, the reality is that the VC-backed company, existing VCs and new investors must come to an arrangement if a further fundraising is to be concluded. This may involve the existing VCs waiving part or all of their anti-dilution adjustment and/or agreeing to an increased option pool for management (to compensate management for significant dilution). From the perspective of the VC with full ratchet anti-dilution protection, such protection may be used primarily as a bargaining "chip" in the negotiations for subsequent financings in which they are not leading the financing.

Minimising the Impact of Full Ratchet Protection

Since the fall in valuations and the slowdown of the IPO and M&A markets, VCs are in a stronger bargaining position and are returning to stricter investment criteria. However, some VCs are realising that harsh terms may act to misalign management and investors' interests and hamper a company in attracting future financing.

If a company has any leverage, it can reduce the impact of anti-dilution protection by basing it on a weighted average formula that is as broad-based as possible. If full-ratchet anti-dilution protection is unavoidable, then one should attempt to limit its effect. The following are popular methods of reducing the effect of a full ratchet provision (and in some cases, a weighted average provision):

  • negotiating a time limit after which the VCs' full ratchet anti-dilution protection switches to a weighted average formula or ceases altogether;
  • negotiating a share price floor, whereby if price per share in the down round is below a specific price the VC would only be entitled to a weighted average anti-dilution protection;
  • negotiating a shareholding percentage cap, whereby any increase in percentage ownership of the company is capped at an agreed level;
  • negotiating performance adjustments, which allow the founders and/or management team to recoup the reduction in their share ownership percentage caused by a down round anti-dilution adjustment once the company has met predetermined milestones; and/or
  • negotiating pay-to-play provisions, which require investors who have anti-dilution protection to exercise their pre-emption rights to invest their pro rata share in subsequent rounds of financing or otherwise lose this protection.

In other words, VCs are required to demonstrate their commitment to the company before receiving the benefit of anti-dilution protection.

While the balance of power will likely be in the favour of VCs for quite some time to come, there are things an investee company can do to minimise the affects of anti-dilution protection in a down round.

About The Author

Struan Penwarden ( is a Senior Partner at Hale and Dorr in London.