Anti-dilution provisions are contractual terms written into contracts that are meant as measures to protect an investor’s interest in the event of issuing new shares in the company.
These rights are usually associated with preferred shares.
When an investor has a stake in a company at a certain valuation, the value of that stake can decrease substantially when the company issues new shares for one reason or another. With the a common reason being the issuing of new shares for new investors in a new round of raising capital for venture capitalists.
For example, if a company has 1,000,000 shares and an investor owns 10% of the shares, it translates to the investor owning 100,000 shares. Should the startup issue 100 more shares to bring in new investors, the total number of shares become 1,100,000. This results in the stake of the being reduced to less than 10%. In this case, should the stakeholder have an anti-dilution provision meant to maintain his interest in the company, then he might be issued new shares or be granted right to purchase a number of additional shares at a lower price so as to maintain the 10% stake.
This invoking of the clause can be structured in a number of various ways. The trigger can also vary. With the most common being to protect the percentage stake or the valuation of the holdings.
The 2 common mechanisms are full ratchet and weighted average.
A private equity firm can often request for such provisions as a term for investing in a startup company due to the inherent risks with new companies where the failure and the total lost of the investment is very possible.
When these company faces setbacks and need more funds to sustain operations, entrepreneurs can often look for more funding and has to lower the valuation of the company since they have not met their projected milestones.
As potential new investors look at the track record of failing to meet targets, the entrepreneur might have to reduce the price of the shares compared to the previous round so as to make it look attractive to financiers. Should this happen, investors from the previous round would find that their holdings in the company have lost value.
As such, these provisions help to protect the value of their initial investment.
Anti-dilution provisions can come in the form of preemptive rights, subscription rights, subscription privileges, veto rights, etc.