You are staring at a term sheet and see a section on anti-dilution. It sounds like a standard legal term, but it dictates how much of the company you keep if things get difficult later.
Anti-dilution provisions are clauses that protect investors if you sell stock at a lower price in the future than the price they paid. This is often called a down round.
Investors want insurance. They are putting money in today at a specific valuation. If the market determines your company is worth less in a year, they want their ownership stake adjusted to reflect that new reality. Without this protection, their original investment effectively bought shares at an inflated price compared to the current market.
The Mechanics of the Down Round
#These provisions remain dormant as long as your company valuation increases. They only trigger when you issue new shares at a price lower than what the protected investors paid.
When this happens, the conversion price of their preferred stock is adjusted downward. This means their preferred stock converts into more common stock than originally agreed upon.
This results in the investor owning a larger percentage of the company to make up for the loss in value. The dilution that would have hit the investor is shifted elsewhere. Usually, it is shifted to you and the common shareholders.
Full Ratchet vs. Weighted Average
#Not all anti-dilution clauses are the same. There are two main methods used to calculate the adjustment. You need to know the difference because the mathematical outcome varies wildly.
Full Ratchet
This is the most aggressive protection for investors and the most punitive for founders. If you sell even a single share at a lower price, the conversion price for the existing investors drops all the way down to that new, lower price.
It does not matter how many shares you sold. The repricing is total. This can wipe out a significant portion of founder equity in a single stroke.
Weighted Average
This is the more common and moderate approach. It takes into account two factors:
- The new lower price
- The number of shares issued at that price
The formula adjusts the conversion price based on how much the new round dilutes the old one. A small round at a lower price causes a small adjustment. A large round causes a large adjustment.
Most term sheets will specify Broad-Based Weighted Average, which is generally friendlier to founders than Narrow-Based Weighted Average.
Implications for Founders
#Anti-dilution provisions are a standard part of venture capital. Trying to remove them entirely is rarely successful or worth the social capital in a negotiation.
However, the type of provision matters. Accepting a full ratchet clause suggests you are desperate or that the investors view the deal as high risk. It creates a scenario where a future stumble becomes catastrophic for your personal ownership stake.
You should ask yourself a few questions when reviewing these terms.
Are you raising at a valuation you can realistic grow into? If your valuation is too high now, you increase the risk of a down round later. That is when these clauses bite.
Understanding the math behind these terms allows you to model out worst-case scenarios. It ensures you know exactly what risks you are taking on as you capitalize your business.