In this edition of Deal Terms Demystified, we look at "Anti-Dilution", a standard term one will encounter while raising capital from institutional investors (lately many angel rounds also have this term).
What is Anti-Dilution?
Anti-Dilution protects your existing investor(s) in case the company raises a down round in the future. To understand this better, let's look at an illustration:
– Founders own 900 shares that constitutes 100% of Company A. Investor X invests Rs. 100 in A and receives 100 shares, i.e., an ownership of 10% (i.e., at a pre-money valuation of Rs. 900 and a post money valuation of Rs. 1,000) (see our post on pre and post money valuation). Now founders own 90% and X owns 10% and founders' ownership has a value of R.s 900.
– In the next round investor Y invests Rs. 80 in A and receives 111 shares, i.e., an ownership of 10% (i.e., at a pre-money valuation of Rs. 720 and a post money valuation of Rs. 800. This is a down round.
Post down round, the value of X's shares falls to 72 (the down round dilutes X's ownership by 1%, i.e., 10% of 10 per cent ownership, or 9% ownership. The value of X's diluted ownership is 9% of 800). Thus post the down round (without factoring in any Anti-Dilution) X and Y would own 19% (9% + 10%). The founders would own 81%. Based on down round valuation, the founders ownership would have a value of Rs. 648 (81% of 800).
Investors hedge the risk of a down round through Anti-Dilution right.
How does Anti-Dilution work?
With Anti-Dilution, earlier investors who invested at valuations higher than the down round valuation get more shares (or the right to get more equity shares when their preference shares are converted).
If one were to give full protection against devaluation in a down round, a pre-down round investor's ownership in the company would have to be hiked to a level which has the value (based on post down round post money valuation) equal to the capital invested by such investor. In the above illustration, X's ownership needs to be bumped up from 9% to 12.5% to achieve this. If so, X and Y would own 22.5%. Founders would own 77.5%, valued at Rs. 620 (77.5% of 800).
Current Market Standard: Anti-Dilution on Broad-Based Weighted Average Basis
The Anti-Dilution model explained above is called 'full ratchet anti-dilution'. The current standard practice in India (and most western markets) is the 'broad-based weighted average anti-dilution' model.
The number of additional shares to be given to an Anti-Dilution protected investor under the broad-based weighted average method is as follows:
A / {(B+C)/(B+D)}
A = Number of shares which were bought by protected investor at valuation higher than down round valuation;
B = Total number of shares issued by the company until the down round;
C = Total number of shares which would have been issued in the down round at the valuation at which the protected investor bought its shares; and
D = Actual number of shares issued in the down round
Applying this formula to our above illustration, let's see how X's ownership increases:
100 / (1080/1111) OR 100/0.97 = 102
That is an increase of 0.2% in X's ownership under the broad-based method. This contrasts starkly with the 3.5% increase in ownership under the full ratchet method.
Broad-based weighted average anti-dilution method is more favourable to the founders (and earlier stage investors not protected by Anti-Dilution) as the dilution for them is lower.
By favouring broad-based weighted average method for Anti-Dilution, professional institutional investors have made the Anti-Dilution term more palatable to the founders, even if it exposes the investors to the risk of value loss.
Founders take note:
Anti-Dilution protection for financial (institutional) investors is a universally standard term in the Indian market, so one should not harbour hopes of negotiating it down. But pay attention to the Anti-Dilution formula and validate that it bears out Anti-Dilution on broad-based weighted average model.
Watch this space for the next instalment of Deal Terms Demystified. In the meanwhile, feel free to share this post with your friends and colleagues you feel would find this helpful.
Originally published 22 November 2019
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.