​

What is anti-dilution?

 

Normally, when a start-up company issues new shares to a later investor, those new shares dilute each shareholder’s proportional ownership of the company.

 

A seed investor or venture capitalist investing in a start-up company will always require an anti-dilution right among the preferential rights of its preference shares.

​

It is an investor’s right to effectively have a “free top-up” in the number of its shares if a later investor is issued shares at a lower price than the price paid by the earlier investor.

 

But it would not normally dilute the value of each shareholder’s existing shares. This is because the capital raised by the issue of new shares increases the company's capital, so the issue of new shares normally leaves the value of each shareholder’s shares unchanged, or even increases it.

 

That will be the case if the second investor’s new shares are issued at a price greater than the price paid by the first investor, as would normally be expected.

 

But what if the second investor’s shares are issued at a price less than the price paid by the first investor?

 

 

The Full Ratchet

 

Suppose:

 

• a start-up company’s pre-investment valuation is $400,000

• there is just one shareholder, a university or research institute, or a founder (“the original shareholder (or OS)), with 400,000 shares

• an investor (A) invests $100,000 for 100,000 Series A Preference Shares, at $1 per share

• there are now 500,000 issued shares of which OS has 80%, and A has 20%

• 6 months later, given prevailing economic conditions and the company’s desperation for capital, a new investor (B) is unwilling to pay more than 25c per share and pays $25,000 for 100,000 shares at 25c per share.

 

There are now 600,000 shares on issue (400,000 + 100,000 + 100,000).

​

If Investor A converts its A’s 100,000 Series A Preference Shares into ordinary shares at $1 per share, the price that it paid for the shares, it would on conversion have 100,000 ordinary shares, which is 16.7% of the start-up company (100,000 / 600,000).

​

However, a full ratchet anti-dilution provision would allow A to convert A’s Series A Preference Shares to ordinary shares, not at the $1 paid by A, but instead at the lowest price for which any shares have been issued by the start-up company after A’s investment, which in this example is 25c.

​

The full ratchet anti-dilution provision works as follows:

​

​

                       NSA    x    OPP          =         NOS

 

                                  LP

 

where: 

​

1. NSA is the number of Series A Preference Shares that the investor is converting to ordinary shares

2. OPP is the original purchase price paid for those Series A Preference Shares by the investor

3. ​LP is the lowest price paid for any share in the start-up company by any shareholder after A’s investment, and 

4. ​NOS is the number of ordinary shares that the investor will receive upon conversion. 

 

Applying this formula to our scenario,

​

​

                       100,000  x  $1             =       400,000

 

                              0.25c

 

There are now 900,000 shares on issue (400,000 + 400,000 + 100,000).

​

By converting its 100,000 Series A Preference Shares into 400,000 ordinary shares, Investor A goes from owning 16.7% of the start-up to 44.4% (400,000 / 900,000).

 

The full ratchet reduces OS’s proportional ownership of the start-up company.

 

 

Is a full ratchet anti-dilution right fair?

​

The rationale for investor A having full ratchet anti-dilution rights is that it protects investor A from having overvalued the start-up company at the time of A’s investment. In other words, if investor A had more accurately valued the company at the time of investing, the price per share that investor A would have paid ($1) would have been the same or less than the price per share paid by the later investor, B (25c).

​

This rationale is often criticized, for several reasons.

​

First, Investor A will have factored risk into its valuation of the start-up company, usually by selecting a high discount rate to plug into its net present value discounted cash flow analysis. That high discount rate results in a pre-investment valuation of the start-up company that accounts for future events that have a devaluing effect, including those that may cause investor B to value the start-up company 6 months later at a lower price per share. On that basis, the original valuation was not an over-valuation when it was undertaken by investor A, and the price paid by investor A at that time already reflected the risk of a lower valuation later.

​

Second, there may be other explanations for the down round (that is, investor B paying 25c per share rather than $1 per share), including: 

​

• the down round occurs not because investor A over-valued, but instead because investor B’s later valuation is an under-valuation

• prevailing economic conditions may impact negatively on the investment climate, with the down round reflecting investor reticence, rather than the company’s value.

 

Third, there may be a later up round (where the price for the issue of new shares exceeds the price paid in earlier rounds, and perhaps even well exceeds the price paid by investor A who wants the full ratchet protection.

 

​

The Weighted Average Ratchet” – a Fairer Approach

​

A fairer approach to be preferred to a Full Ratchet, is a Weighted Average Ratchet.

 

This will be the subject of the next issue of IP Bits.

​

​

Other Issues of IP Bits

 

You may be interested in other IP Bits issues that concern start-ups and venture capital investment:

​

• Glossary of Terms Used by Venture Capitalists

• Venture Capitalists' Investment Criteria

 

​

 

​​

​

​

​