Accordingly, venture capital investors who are minority shareholders and unable by themselves to vote down any shareholder resolutions which may be proposed authorising the board to issue new equity securities, often require anti-dilution mechanisms to be adopted which protect their investment from dilution in the event of any future fundraisings.
Although an outright veto on any new equity securities being issued by the company is the most effective type of anti-dilution provision since it gives an investor total control of whether the company can issue any new equity securities, it is relatively rare since the company and the other shareholders will usually insist that the company should be able to issue additional equity securities should the company require new finance in the future and debt finance is not available.
Price based anti-dilution provisions
Price based anti-dilution provisions are used by investors who wish to protect themselves against a company issuing additional shares at a share price which is lower than the share price which they paid. This is a real risk for investors especially in early stage companies where valuations may have been stretched or the company is pre-revenue.
This type of funding round is commonly known as a 'down round' and they are particularly unwelcome for investors as the lower down round share price magnifies the dilutive effect of the new equity securities being issued.
To counter the effects of a down round, investors have developed anti-dilution provisions called 'ratchets' which enable the investor to receive additional shares for nil or very little further payment by adjusting the price they originally paid for their shares.
Different types of 'ratchets' are used by investors and these can have different consequences for the other shareholders. There are two main types of ratchets:
- Full ratchet – where the investor's original investment is re-priced at the share price of the down round and the investor receives a bonus issue of new shares to increase its shareholding to what it would have received had its original investment been made at the down round price. This is the strongest type of anti-dilution ratchet protection for an investor but full ratchet protections are usually resisted by investee companies and other shareholders since it can make the company less attractive to future investors and can also lead to additional dilution for shareholders who do not also benefit from such provisions (e.g. employee and management shareholders).
- Weighted average ratchet – this is the more common form of ratchet used by investors and it seeks to take into account the extent of the investee company's issued share capital when re-pricing the investor's investment price, the theory being that it is unfair to completely re-price all of an investor's original investment in respect of a down round which might be relatively small in comparison to the overall issued share capital of the company. To put it another way, the weighted average ratchet seeks to better measure what the extent of the increase to the issued share capital of the company is as a result of the down round.
Weighted average ratchets can either be broad based or narrow based. A narrow based ratchet will take into account only the actual issued share capital of the company but a broad based ratchet will also take into account any unexercised share options, convertible securities, warrants and so on.
A broad based ratchet will be of most benefit to other shareholders since it increases the potential size of the company's share capital against which any ratchet is to be calculated.
Other key negotiation points
In addition to negotiating the types of anti-dilution protections which might be employed, other potential areas for negotiation include:
- Pay-to play: these provisions provide that if an investor does not participate at all or fails to take up a pre-defined minimum percentage of new shares (by reference to their entitlement under the pre-emption provisions) under any down round, they may lose some or all of their anti-dilution protection. These are generally used to incentivise investors to participate in future fundraisings (including any down rounds) and are a useful tool to ensure that the investors continue to reinvest in the company. Pay to play provisions can also be drafted so that they:
- reward investors who exercise pre-emption rights by exchanging their existing shares with either
- a similar class of shares having better economic rights or
- a new class of shares with better rights attached to them; or
- punish investors who fail to exercise their pre-emption rights in a new round of fundraising by either
- forfeiting their price-based anti-dilution protection or
- converting their existing shares to a new class with fewer rights attached.
- reward investors who exercise pre-emption rights by exchanging their existing shares with either
- Ownership threshold: a company can seek to restrict granting anti-dilution protection rights to investors whose equity ownership exceeds a minimum threshold. If the categories of investors benefitting from such protections are too large, this can become administratively cumbersome for the company and may limit the company's ability to undertake further fundraising rounds.
- Exceptions to price-based anti-dilution protections: it is usual to exclude certain types of new equity securities issues from the price-based anti-dilution provisions and such exceptions will vary from transaction to transaction but commonly these include new issues of equity securities:
- to existing investors on any conversion of their pre-existing options, warrants or other convertible securities; and
- after the date of the relevant investment round, to directors, officers, employees or consultants of the investee company pursuant to exercise of any stock options or other incentive equity.
Generally, anti-dilution provisions are tailored and adopted depending on the nature and scale of the investment and as ever the respective bargaining position of the parties involved.
DWF has a market leading venture and growth capital practice in the UK, supporting investors and companies across several sectors including financial services, technology, media and telecommunications, life sciences and healthcare and real estate and infrastructure. If you have queries on any of the issues covered in this article please contact one of our experts.
We would like to thank Amaan Shar Baloch and Adil Jahanghir for their contributions to this article.
