Anatomy of a Term Sheet - Anti-Dilution I

read time: 7 mins

For more information on this post contact Scott Preece.


A common feature of emerging growth companies and start-ups is the need for new funds. Each new fundraising will likely have an economic impact on an investor’s investment in the Company. Hopefully, (regardless of whether the investor participated in the fundraising), the shares held by an Investor will increase in value, as the total valuation attributed to the company will increase incrementally over time (an “up-round”). However, in the event that the total valuation attributed to the company in a new fundraising is less than the last round (or previous rounds) (a “down-round”) not only will an investor’s ownership decrease so will the value of its investment.

For example, a company has an issued share capital of 1,000,000 ordinary shares. Investor A subscribes for 1,000,000 Series A Shares in the company for £1,000,000 at a pre-money valuation of £1,000,000. The post-money valuation is therefore, £2,000,000 and the price per share would be £1.00 (see earlier post).

If the company raises a further £500,000 by issuing 1,000,000 Series B Shares to Investor B, the company’s post-money valuation would now £1,500,000 and the price per share would be £0.50 per share. Investor A’s investment would now be worth £500,000 (1,000,000*£0.50) and his ownership would decrease from 50% to 33% of the company.

Anti-dilution provisions seek to protect an Investor’s ownership from the dilution suffered in a down-round financing. This results in all shareholders without anti-dilution protection (usually employees, management and other ordinary shareholders), bearing the brunt of the dilution, rather than being shared equally by all shareholders. In the UK, this protection is achieved by either (i) issuing more shares to the Investors (a “Bonus Issue”) or (ii) increasing the number of shares of Ordinary Shares into which each Preferred Share held by an Investor will convert following a down-round (the “Conversion Mechanic”). The mechanics of anti-dilution and types of anti-dilution are explained below.

Anti-dilution should not be confused with pre-emption or rights of first refusal. These rights enable an existing Investor to purchase a portion of any new issue of shares in order to preserve or increase their ownership. This right is triggered regardless of whether the new issue is a down-round or an up-round. As you will see in a future post, anti-dilution provisions protect an Investor without requiring the Investor to pay more (except in the case of pay-to-play provisions), whereas a pre-emptive right requires the Investor to put his hand in his pocket to receive the benefit of the protection.

As mentioned previously, companies and entrepreneurs should not always accept a term sheet with the highest valuation. This can increase the risk (i) that an Investor will insist on very punitive anti-dilution provisions, such as a full-ratchet (this will be dealt with in a future post) and (ii) that a future fundraising will be a down-round, and therefore more likely to trigger the anti-dilution provisions.

Entrepreneurs and companies need to understand the impact of the provisions to the other shareholders and try to mitigate the impact as far as possible. Companies should be wary of any term sheets containing terms such as “standard anti-dilution protection”, as there is no agreed standard. Companies should ensure that the anti-dilution provisions are expressly set out in the term sheet so there can be no ambiguity (some VCs actually include an example appended to the term sheet).


In the UK there are two common methods used for providing anti-dilution protection (you occasionally see the use of warrants but this post will not describe them here):

Bonus Issue

The most common anti-dilution mechanic in the UK is a “bonus issue” of shares. In the event of a down-round financing, the company would issue new shares (usually the same class of shares held by the Investor) to the Investor(s) (the “Anti-dilution Shares”). The Anti-dilution Shares are ‘paid for’ by transferring money from the company’s reserves (in the case of a start-up this is usually paid out of its share premium account) into its equity capital. In the event that the company has insufficient reserves (i.e. the company does not have any profits or has exhausted its share premium account) to issue the Anti-dilution Shares, then the Investor will subscribe for the Anti-dilution Shares at nominal value. If the Bonus Issue mechanic is used, the Investor will typically insist on the nominal value of the Preferred Shares to be very low. If the nominal value of a share is high (for example £1.00) an Investor would potentially have to pay significant amounts to exercise his anti-dilution rights.

Conversion Ratio

This is the mechanic used in most US transactions. As stated in a previous post, the Preferred Shares held by an Investor are usually convertible into Ordinary Shares on the occurrence of certain events. The conversion ratio will initially start on a one-for-one basis. If a conversion ratio mechanic is used, the conversion ratio is adjusted so that on conversion the number of Ordinary Shares into which each Preferred Share converts is increased. In addition, the dividend and voting rights of the company’s shareholders will be adjusted, as the holders of Preferred Shares will be entitled to vote or participate in any dividend on an as-converted basis.

Most term sheets tend to suggest that anti-dilution is done on a conversion basis (this is because many VCs use US style term sheets) however, when you receive the first draft of the legals you will probably find that they contain the bonus issue mechanic. If possible, companies are advised to adopt the conversion mechanic for the following reasons:

Flexibility — the conversion ratio is more flexible than the bonus issue mechanic. If any changes are agreed following any dilutive event, then it is relatively easy to amend the conversion ratio without trying to ‘claw-back’ any Anti-Dilution Shares;

Preserves the Deal Economics — many investment agreements (including the BVCA Model Documents) hard-wire the liquidation preference amount into the Company’s articles of association (i.e. the liquidation preference will be defined as £XX per preferred share). This is to ensure that there is no ambiguity as to the liquidation preference. If the liquidation preference amount is hard-wired and the company issues Preferred Shares as Anti-dilution Shares (which is generally the case), such Anti-dilution Shares will have the effect of increasing the liquidation preference amount to the Investor.

For example, a company issues 1,000,000 Series A Shares to Investor A. Each Series A Share has a liquidation preference of £1 per share. In a down-round financing the company issues 500,000 additional Series A Shares through a bonus issue to Investor A. Following the bonus issue, Investor A’s aggregate liquidation preference amount will be £1,500,000. If a conversion mechanic had been used, the aggregate liquidation preference amount would have been untouched.

Companies should also look at any preferred dividends or redemption rights in the context of a down-round financing. As stated above the purpose of anti-dilution protection is to seek to protect an Investor’s ownership from the dilution suffered in a down-round financing, rather than improve such Investor’s economics.

If an Investor (or their lawyers) insists upon using a bonus issue mechanic, companies should ensure either that (i) the legal documentation also includes an adjustment mechanism to the liquidation preference/preferred dividend/redemption rights in the event of an issue of Anti-Dilution Shares or (ii) that Ordinary Shares (which carry no such rights) are issued as Anti-Dilution Shares (which is likely to be less palatable to an Investor).

Further Down-rounds — in the unfortunate event of multiple down-rounds, the conversion ratio is more favourable to the holders of Ordinary Shares. All anti-dilution calculations (please see the next post) run off the original investment price. Using the conversion ratio mechanism, the original investment price is adjusted (it is usually averaged down), which means the “trigger price” will decrease on each down-round. With a bonus issue mechanic the original investment price tends to remain constant (which means that more anti-dilution shares would be issued). Again, if an Investor insists upon using a bonus issue, companies should try to negotiate that the anti-dilution provisions contain adjustment provisions in the event of an issue of Anti-dilution Shares.

The Anatomy of a Term Sheet series can be found in full here

Sign up for legal insights

We produce a range of insights and publications to help keep our clients up-to-date with legal and sector developments.  

Sign up