Anti-dilution protection

What it means

Anti-dilution protection is a term in an investment agreement or shareholders’ agreement that protects an investor against a down round, where the company sells equity in a later funding round more cheaply than the investor paid. Without protection, the paper value of the investment would fall.

It is not protection against ordinary dilution. When a company takes on a new investor at a higher price, everyone’s percentage falls but the value rises, and the anti-dilution clause does not address that. It is triggered only when the new price per share is lower than the original one.

The two most common forms are full ratchet, which recalculates the investor’s stake as if it had bought everything at the new lower price, and weighted average, which takes into account how much money came in during the new round and gives a milder adjustment. The difference between them can amount to tens of percent of the company for the founders.

How it works in practice

In a Slovak s. r. o. the protection is delivered by giving the investor an additional stake, for example through a transfer from the founders or an increase of its contribution for a nominal sum. Every such change must be reflected in the articles and the commercial register, so the mechanism must be agreed precisely in advance.

When negotiating the term sheet we advise founders to insist on weighted average rather than full ratchet and on carve-outs, for instance for employee plan shares or loan conversions. It is worth modelling the clause on the cap table at various prices for the next round.

From a tax point of view, receiving a stake for free or on favourable terms may raise the question of whether it is income for the investor or a gift. For transfers between shareholders we therefore always assess the tax consequences and whether the valuation matches the usual market price.

What to watch out for

Founders often sign a full ratchet convinced the company will only grow. If hard times come and money has to be raised at a lower valuation, full investor protection combined with a liquidation preference can strip the founders of most of the company, and with it their motivation to carry on.

The interplay of several investors with different clauses is another problem. When one investor’s protection kicks in, it changes the others’ percentages and may trigger further mechanisms. Without a spreadsheet model it is hard to predict who will own how much after a down round.