There are some important clauses in the shareholder agreement that we tend to overlook. In this article, we will take a look at one of them. The anti-dilution provisions need to be understood & their impact on your ownership. In the case of a reduction in the number of shares or an increase in the price of those shares, the anti-dilution provisions are intended to prevent any dilution of the shareholders’ ownership interest.
In every Shareholders’ Agreement with investors, there is an anti-dilution clause. Other names for this provision include “Prevention of Dilution” or “Anti Dilution Provisions”. However, many entrepreneurs are unaware of the impact of these key terms should things go sour. If you need assistance in understanding the complex legal terminology of anti-dilution clauses, we will simplify it for you.
How do startups protect themselves against dilution?
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Investments are protected from downsizing due to anti-dilution during subsequent funding rounds. The entity will be valued at a lower price in the next round of funding, so new shares will be issued at a lower premium. Existing investors will lose value if new shares are issued at a lower premium. So, anti-dilution clauses are inserted to ensure that the investment remains valuable. New shares are issued or the issue price is adjusted to safeguard the value of investors.
The two most common models of anti-dilution rights are:
- Full Ratchet
- Weighted Average
Full Ratchet:
New shares will be issued for the surplus investment made by the existing investor when new shares are issued at a lower price.
For example, suppose Series A shares are valued at Rs. 100 and Series B shares are priced at Rs. 90. In such a scenario, the investor who bought shares at Rs. 100 will be issued new shares equal to his excess investment amount (i.e. Rs. 10 x number of shares invested). The existing investor’s percentage holding will remain intact in this case. As a consequence, the promoter’s shareholdings are diluted significantly, hence, this is a one-sided model.
Weighted Average:
Compared to the Full Ratchet model, this one is lenient. The Company issues new shares at an adjusted price when the Weighted Average anti-dilution clause is triggered. Adding the issue price of outstanding, new, and existing investments, along with the aggregate consideration received, results in a weighted average price adjustment. Here is an example.
| Series A Funding at Rs. 100/- per share | No. of Shares | Investment Value | % of holding |
| Promoters | 90,000 | 90,00,000 | 90% |
| Existing Investor | 10,000 | 10,00,000 | 10% |
| Total | 1,00,000 | 1,00,00,000 | 100% |
For example, assume a new investor invests Rs. 9,00,000 to acquire 10,000 shares at Rs. 90/- and a 10% equity stake is acquired. The consideration price for Series B funding will now be determined using a weighted average formula in order to protect existing investors:
Consideration B = Consideration A*(No. of outstanding shares + No. of shares to be issued in Series B at Consideration A)/ (No. of outstanding shares + No. of shares to be issued in Series B at Consideration B)
=100[1,00,000+(9,00,000/100)]/[1,00,000+(9,00,000/90)]
=100[1,00,000+9000]/[1,00,000+10,000]
=99.09
An existing investor will receive approximately 92 shares at the new consideration price. Also, the promoters’ holdings would be diluted, but not significantly more so than in the Full Ratchet model.
Guidelines and Regulations for Pricing:
The price per share should not be lower than the fair price determined by an independent valuer in the further issuance in accordance with the Companies Act, 2013. The enforceability of the provisions can be a problem if the adjusted price per share is less than the fair price recommended. Legal matters should always be handled by experts