Anti-dilution protections – safeguarding investor equity

In venture capital, anti-dilution protections are a critical mechanism designed to protect investors from the impact of a down-round, where new shares are issued at a price lower than in previous funding rounds. 

These provisions ensure that investors retain the economic value of their original investment while distributing the dilution impact across other shareholders, often founders.

There are two common methods of implementing anti-dilution protections: bonus issues and conversion adjustments. Both approaches achieve the same goal but differ in execution and implications for cap tables and shareholder equity. 

This article in our ‘Anatomy of a term sheet’ series explains these mechanisms, explores different types of anti-dilution protections, and analyses their effects from the perspectives of founders and investors.

What are anti-dilution protections?

Anti-dilution protections safeguard investors against the erosion of their ownership value in a down-round by adjusting their shareholdings or conversion price. The adjustment typically ensures that investors maintain an economic position consistent with their earlier investment.

Two primary mechanisms are used to implement anti-dilution protections:

• Bonus issue: additional shares are issued to investors at nominal value to adjust their ownership percentage.
• Conversion adjustment: the conversion price of preference shares is adjusted, increasing the number of ordinary shares the investor receives upon conversion.

Each method has its nuances, advantages, and trade-offs.

Bonus issue vs conversion adjustment

Bonus issue

• Mechanism: bonus shares are issued to preference shareholders at nominal value, increasing their total shareholding to compensate for the lower price of the new issuance.
  
  
• Advantages:
  • Simple to implement and transparent in cap table adjustments.
  • Preserves the original liquidation preference per share, avoiding recalculations.
  • Immediately reflects adjustments in issued shares, providing clarity to all stakeholders.
• Disadvantages:
  • Increases the total number of issued shares, which may complicate future rounds.
  • Requires sufficient authorised share capital to accommodate the bonus issue.

Conversion adjustment

• Mechanism: the conversion price of preference shares is reduced to reflect the lower price of the new shares, increasing the number of ordinary shares the investor can receive upon conversion.
  
  
• Advantages:
  • Avoids issuing additional shares upfront, simplifying the overall share issuance process.
  • Commonly used in jurisdictions like the us, where conversion adjustments are more typical in term sheets.
• Disadvantages:
  • Requires recalculations that can complicate equity and voting structures.
  • May affect the voting power or liquidation preference structure if conversion occurs prematurely.

While bonus issues are more common in UK and European deals, conversion adjustments are frequently used in the US or in convertible note structures. The choice often depends on local market practices and deal complexity.

Types of anti-dilution protection

Regardless of the mechanism, the type of anti-dilution protection determines the extent of the adjustment. The two main approaches are full ratchet and weighted average.

Full ratchet anti-dilution

• Mechanism: adjusts the investor’s economic position as though they had originally invested at the lower share price of the down-round.
• Impact: maximally protects investors but is highly dilutive to founders and other shareholders.

Full ratchet is rare in balanced deals due to its aggressive nature and significant dilution for founders.

Weighted average anti-dilution

Weighted average anti-dilution protection is more nuanced and adjusts the investor’s position based on the size and price of the down-round relative to the existing share capital.

• Broad-based weighted average: includes all shares, options, and convertible securities in the calculation, reducing the dilution impact on founders.
• Narrow-based weighted average: excludes options and other dilutive instruments, increasing the dilution impact on founders.

Negotiation strategies

For founders

• Favour broad-based weighted average: this minimises dilution compared to full ratchet.
• Push for pay-to-play clauses: require investors to participate in down-rounds to benefit from anti-dilution protections.
• Model scenarios: evaluate the impact of bonus issues and conversion adjustments on future equity dynamics.

For investors

• Insist on anti-dilution protections: weighted average protection balances fairness with downside risk mitigation.
• Understand the mechanism: bonus issues are easier to manage in some jurisdictions, while conversion adjustments may suit others.
• Preserve economic rights: ensure adjustments align with liquidation preferences and other negotiated terms.

Analysis: founders’ perspective vs investors’ perspective 

In summary

Anti-dilution protections are essential in venture capital, helping investors manage risk while shaping the long-term equity dynamics of the business. Whether through bonus issues or conversion adjustments, the mechanism should align with market norms and the company’s needs. By negotiating carefully, founders and investors can achieve a fair balance that supports growth and sustainability.

Read the next article in our "Anatomy of a term sheet" series, where we’ll explore some of the other economic terms you commonly see in a term sheet, including Tranched Investments, Preference Dividends, and Growth Shares, to uncover how these provisions shape the financial dynamics of a venture capital deal. 

If you're navigating the complexities of venture capital term sheets or preparing your business for investment, our experienced team is here to help. Get in touch to discuss how we can support you in securing the right deal for your business.

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