When you are starting up a company or your company is at its initial state, you need to be careful about every titbit of the Shareholders Agreement (SHA) and also be updated and aware of anti-dilution rights. Many a time, as an investor, you agree with every clause mentioned in the Shareholders Agreement (SHA) because you are in dire need of the funds and don’t want to waste your time. However, it is always important that, as an investor, you thoroughly scrutinize all the Shareholders Agreement (SHA) provisions to avoid any jeopardy in the future. For this, the anti-dilution adjustment clause is introduced, which should be monitored periodically.
The anti-dilution clauses are generally present in the Merger and Acquisition (M&A) agreement or the security agreement of the company.
Anti-dilution protection clause is provided to protect the investors from any lowered pricing of securities if he has bought the company shares at a higher price during the earlier issue. The investors have a right to retain the same percentage of ownership despite the additional issue of shares at a lower price in the future.
So, what actually is Anti-Dilution protection, and how does it benefit you as a founder, or how does it actually protect the investor’s rights?
But before discussing the concept and significance of anti-dilution protection, it is important to know what dilution is. How does it affect the investors’ rights?
What is dilution?
Dilution reduces the ownership stated in percentage terms. It can happen when a company issues new shares or when there is an increase in the number of shares outstanding.
Dilution occurs when a company issues new shares or increases the number of outstanding shares. This means that there is an increase in the total number of shares available and, therefore, a decrease in each shareholder’s share of ownership.
When the dilution takes place, each share’s value decreases, which can adversely affect the company’s performance if it does not have enough capital to invest.
Issuance of new shares is one of the most common causes of share dilution. The company might issue new shares to raise capital, reward employees, or give them as gifts. In some cases, companies issue new shares in exchange for assets they acquire from other companies.
For instance, a company has issued shares by following an additional round of investment, thus, diluting the total percentage of existing investors. Additional investment will definitely increase the value of the company, but in case, the company fails to perform as per expectation leading to declining in the total value of the shares and thus, reducing the rights of existing shareholders. Such instances lead to the initiation of anti-dilution protection by the investors to retain the existing percentage in the company.
You must be wondering why it is so important to prevent shareholder dilution.
Shareholder dilution is a risk that investors take when they invest in a company. It happens when the shares of a company are issued to the public and the percentage of ownership decreases for each share.
The problem with shareholder dilution is that it can affect the earnings per share (EPS) and stock price, which will affect the value of your investment. Thus, it is important to prevent shareholders dilution.
What is Anti-dilution Protection?
Anti-dilution protection is a legal term that is used in the context of securities law. It refers to a set of rules designed to protect shareholders’ interests. The anti-dilution agreement is a type of corporate law that prevents diluting a company’s shares without its permission. It also ensures that there is fair treatment for all the shareholders.
Anti-dilution protection is offered by companies when they issue new shares at a lower price than the market price. When the company issues additional shares as lower prices than the earlier price of the shares in the market to acquire additional funding, the investors who have already bought the shares at the higher rates get insecure regarding the right and proportion of shares they are holding, with a fear of losing their rights to the new shareholders.
It should be noted that the anti-dilution protection comes into existence only when the company issues the shares at lower prices than the earlier issue price, also known as the “down rounds”. In case, the shares are issued at a higher in the subsequent issue, the share price of the existing shareholders will already increase, ensuing in a decline in the shareholding percentage. Since the shareholders already enjoy higher prices, anti-dilution protection is not questioned.
Exceptions in the anti-dilution protection
While you are considering the situation where the anti-dilution protection is applicable, there are a few instances that are excluded from the application of anti-dilution protection.
- The anti-dilution protection is excluded in the scenarios of Employee Stock Options (ESOs) where the employees of the companies are offered equity compensation plans. Under the ESOs the company provides derivative options to its employees instead of providing the equity shares directly. The options are generally in the form of call options that provide the employees the right to buy the company shares at specific prices for a limited period.
- When there is a public offer for sale or transfer of shares offered by the company or its subsidiaries, or by any person acting in concert with them
- When there has been an amalgamation with another company
- When there has been an allotment of securities for cash consideration
- When there has been an allotment of securities as consideration for acquisition by one company of a promising business, property, or undertaking of another company
How can a company’s shareholders benefit from anti-dilution protection?
Anti-Dilution Protection is a common clause in the incorporation articles that protects shareholders from dilution of their ownership stake.
It ensures that the company’s shareholders will maintain their percentage ownership in the company even if the number of shares increases due to future financing rounds.
This is important for any shareholder who has a significant stake in the company and wants to maintain his or her current shareholding position. Anti-dilution clauses are especially important for founders, who need to protect their ownership stake from dilution by new investors.
What are the different types of anti-dilution provisions?
There are mainly two types of anti-dilution protection:
Full Ratchet: Full Rachet method advocates the revision of the conversion price of the existing investors when the shares issued in the next round of investment are issued lower than the earlier price. In this scenario, the new share prices paid are lower than the prices paid by the existing shareholder, thus, limiting their rights and lowering their share value as well. Hence, in order to compensate the existing shareholders, the company will issue further shares to the existing shareholders considering the surplus amount that would be paid after making relevant adjustments in the existing amount, which does not require any extra amount to be paid by the existing investors. It is also possible that the conversion price may be revised to the current price at which the shares have been issued.
In this Full Ratchet Method, it is not important how many shares are held by the existing shareholders, or how many shares have been issued in the subsequent share round. The most vital aspect is the new issued price that is applicable for all the shareholders, including the existing and the new ones.
This method may seem hard on the founders as well as the company as the total shareholding percentage as there is a possibility that the founders may dilute their shares at a greater extent.
Broad-Based Weighted Average: this method uses a specific formula to consider the total number of shares issued, unlike the Full Ratchet method, which considers the price of the shares held by the existing shareholders.
The method considers the weighted average method of calculating the price, which ultimately seems to be fair to the founders and the company. It considers the existing price/conversion price and the total number of shares outstanding to calculate the weighted average method. Here, the number of outstanding shares is the ones that have been lately issued along with the purchase consideration which the company may receive as issuance in case of any purchases made by the company.
Beneficiaries of the anti-dilution protection
Anti-dilution protection for founders: If you are wondering why the anti-dilution protection clause is only for investors, then you are probably thinking it wrong. This clause is equally beneficial for the founders as well.
The anti-dilution protection for founders helps them to seek higher valuation every time they decide to raise additional funding by issuing shares in the market. The anti-dilution protection for founders always motivates them to incentivize the company by performing better with the expansion of capital in the future. Thus, the anti-dilution protection is also equally in favor of the founders as it is for the investors in the company.
Anti-dilution protection for investors: When the company’s founders decide to raise more funds from the market at a lower price than the earlier issued price, the existing investors may feel insecure in terms of loss of the value of their portfolio as the market price of the security decreases. However, you don’t have to worry as an investor because there is anti-dilution protection for investors. The anti-dilution protection for investors provides security to existing investors against the losses that may occur to them as a result of the lower valuation of the security price during the subsequent round of fundraising. Under the anti-dilution protection, the investors are provided an automatic right that protects their interest in terms of lower valuation of securities when the founders decide to borrow funds from the market at a reduced cost. The anti-dilution clause helps to safeguard the interest of the investor.
In the present situation, when the companies are looking for funding and they have to opt for the successive issue of shares to acquire more funds for the company creates a lot of difficulties.
The issue of share prices in the following round of shares at a price below the existing price leads to the dilution of the percentage of actual shares of the existing shareholder, creating insecurity among them.
The anti-dilution protection may seem a secure option for them. However, it is a great challenge to implement it practically. Thus, anti-dilution protection is only possible if some significant changes are proposed in the law to protect the existing investors’ interests.
Finally, the investors as well as the founders need to understand the implication of the anti-dilution protection clause. With higher numbers of foreign investors taking an interest in India, it is important that the founders and the companies should start focusing on conscripting of appropriate clauses in the agreement. Since there has been a considerable increase in the risk and the market conditions, more focus should be on the building values.