What doe Anti Dilution Clause Mean?
Anti dilution clauses are provisions built into some options and convertible preferred stocks to protect an investor’s stake from losing value in subsequent financing rounds. Equity dilution could occur when:
- New versions of a stock are rolled into the market at a lower price than what earlier investors paid.
- The total number of outstanding shares increases. It dilutes the investors stake even if the shares are issued at the same price. An investor who held 20 percent of a company that had 100 outstanding shares will hold a 10 percent stake if the number of issued shares increases to 200.
- Employees and other holders of optionable securities exercise these options.
Anti dilution clauses are also referred to as anti-dilution protection, anti-dilution provisions, preemptive rights, subscription privileges, or subscription rights.
Anti dilution provisions usually come in two forms:
- Full ratchet: The conversion of preferred shares is adjusted downward to align with the price of new shares in subsequent rounds.
- Weighted average: Calculating the new conversion price based on old conversion price (A), outstanding shares before new issue (B), number of new shares (C) and total consideration the company receives for the new shares (D). The formula’s format is as follows:
New conversion price = A x (B + D) / (B + C)
There are times the dilution transaction increases the value of the shares thus effectively offsetting the value dilution. This is however not common.