Anti-dilution protection is available as a provision in a convertible security or option, protecting an investor from lower stock prices than what they paid in the past.

Why Does it Matter if a Company Does a Down Round?

When a stock price drops in a down round, this action is typically viewed in a harsher light than a flat round or up round. Even a drop of just $0.05 per share in a down round will cause more negative results than a $0.05 per share up round would have brought positive results. The stock prices for public companies fluctuate by the day. The fluctuations can be caused by economic or industry conditions that aren't unique or specific to the company. These dips provide opportunities to buy for investors but don't necessarily reflect the company's intrinsic value.

However, private companies are different for several reasons:

  • Anti-dilution protection: Some companies offer preferred stock, which may come with its own anti-dilution protection. This protection could magnify the dilution of stock values to common shareholders. If a previous round of investments was previously negotiated at a higher price or with assumptions that are later proven to be false, investors may look to renegotiate the stock value of that previous round. By doing so, the price will reflect the value of the company with the benefit of hindsight.
  • Damaging psychology: A company backed by venture capital is more likely to be a risky, unprofitable endeavor. This type of company might need to provide evidence of growth more frequently to attract and retain talent and capital. If a company is willing to raise capital at a declining value or price for shares of its stock, this action can damage the morale of the employees.
  • Investor accounting: If the limited partners of a business are based on their portfolios' security values, the pricing may reflect this requirement. During a down round, an existing investor may be required to lessen the value of what they currently hold in their personal financial statements. As a result, the company may have trouble raising additional funds or distributing dividends to general partners.

What is Dilution Protection?

When shares of stock are sold at a lower price per share than what was paid by previous investors, the stock is experiencing dilution. To protect their rights, investors will usually make sure that the term sheet includes an anti-dilution clause. Those who haven't invested in the past may wonder why it's not considered dilution if the ownership percentage is reduced but shares are sold at the higher value.

In this example, the higher value of the stock implies an increase in the company valuation, even though the company ownership is diluted. Therefore, the value of the investment you made into the company would increase, which would be a positive outcome. Protection from dilution includes provisions in a contract that prevent or limit the stake of an investor from a reduction when the company seeks to raise additional funds.

Anti-Dilution Protection

Anti-dilution protection also includes a provision allowing an investor to maintain eligibility for a higher percentage of ownership in the company, based on the value before the next round of financing. This provision typically applies when a company has a down round. The provision will be enforced if the company's actions lower the claim on business assets held by the investor.

For example, if an investor holds a stake of 15 percent of the business and the company plans to undergo an additional round of funding, discounted shares must be offered to the investor. This action serves to make up for the overall ownership stake dilution, at least in part. A venture capital funding agreement will often include a provision for dilution protection.

You might hear this provision referred to as anti-dilution protection. Either phrase refers to any type of obligation within a contract to protect the ownership interest of shareholders within a company. Anti-dilution protection is frequently seen in the world of venture capital, especially with startup businesses in the early stages. Companies often need to offer dilution protection to entice people to invest in potentially risky business ventures. By doing so, the investors are protected but the business may feel the impact during future rounds of funding.

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