This blog is an attempt to simplify the complex legal jargon used in Investments typically Private Equity Deals. I have decided to start with the most complex of the lot which gives nightmares to most of my colleagues. My attempt will be to simply put the concept behind Anti-Dilution, the legal complexities of it I shall reserve for another blog on the subject (I really think it deserves another one!)

Anti-Dilution is a standard clause in most private equity/venture capital investments and rarely will an investment get negotiated without some or other form of Anti-Dilution Clause. We can also call Pre-emptive Rights clauses as a form of anti-dilution but the typical anti-dilution clause in the investment agreements has a different aspect. Anti-dilution price protection gives investors in early rounds ( also called Series A investment/ first investment etc.) the benefit of a reduced effective price per share if the company/issuer issues its shares in a later round at a lower price (also called Series B investment/ down round etc.).

Simply put Anti-Dilution allows an early round investor to get new free shares from the Company. Sounds unfair? Let’s examine it in five aspects: (i) When does investor get free shares? (ii) Why does he get free shares? (iii) How many free shares does he get? (iv) How do free shares get issued legally? (v) What does new free share mean for the company and the promoter?

For the purpose of this note we shall consider a standard example of a Company called ‘Startup’. So when our Startup is starting out an investor walks in and decides to fund the Startup. Startup gets its first investment from ‘Peter’. But Peter gets an agreement signed to protect his investment and includes an anti-dilution clause in it.

Now, our Startup doesn’t do really well so it needs more money, it asks Peter but he refuses. Startup now finds another investor ‘Adam’. Because the Company isn’t doing well and it needs more money Adam is able to negotiate a better price than Peter. The anti-dilution clause of Peter now comes into play. What happens when it comes into play, we will find out below:

When does Peter get free shares?

Typically when the later round of funding, happens in a company at a lower price than the early round of funding in that company than the investors in the early round trigger their anti-dilution protection. So taking our example if Peter got his shares at Rs. 100/share and when Adam came for investment his shares were at the cost of Rs. 80/share than in that case Peter shall be entitled to get free shares as per the anti-dilution clause. But, if Adam was getting shares at Rs. 110/share (which is more than price at which Peter got his shares) in that case the anti-dilution would not get triggered. So even though the shareholding percentage of Peter will drop in the second case he will still not be diluted. How?

Why does Peter get free shares?

Anti-dilution clauses are to prevent the dilution of investor shares as a consequence of lowering of Company Valuation and not the percentage shareholding of shares in the Company. This is because if the next round of funding happens at a higher company valuation it means an increase in price of shares for the earlier investor too. So when Adam buys shares at Rs. 110/shares the Startup shares are valued at Rs. 110/share, which means that the price for Peter’s shares is also Rs. 110/share {Please see the note on Company Valuation to understand how this works}. So Peter is happy and even though his percentage in Startup will decrease his overall value has increased.

So what happens when Adam buys shares at Rs. 80/shares? – the opposite. The value of each Peter shares becomes Rs. 80/share. Which means the total investment of Peter gets diluted. How?

Let’s say Peter bought 80 shares @ Rs. 100/share for a total investment of (80 * 100) = Rs. 8000. When his shares become Rs. 80/share his value of investment becomes (80 *80) = Rs. 6400. So now Peter wants promoter(s) of Startup to compensate him for this dilution or loss in investment of Rs. 1600. Why should promoter(s) of Startup compensate? What did they do?

Promoters of any company are responsible for running the company, investors only put in the money to the company and expect their returns. Also for a startup company the Company Valuation taken for first round of funding though undertaken by an independent valuation expert is based on the promoter projections, estimates and promises. Thus the investors hold the promoter of a company responsible for lowering of their investment and want to be compensated for their loss in investment.

Still seems unfair?

How many free shares does Peter get?

This is the most crucial question. Investor always wants to get more shares and the company would like to always reduce the number of free shares. There have been a lot of study on this aspect and the finance guys have come up with lot of formulas and methods to calculate the number of shares. The most commonly used methods are Full Ratchet, Broad Based Weighted Average and Narrow Based Weighted Average. These are the most commonly used and not the only used. Each investor can come up with innovative methods to compensate him for his loss.

Lets discuss the 3 methods mentioned above (you will find them most commonly in term sheets and shareholders agreements):

Full Ratchet

Full ratchet anti-dilution simply assumes that the shares issued to the first investor were issued at a subsequent lower price at which the second or a later investor is getting his shares. The number of shares getting issued in any round has no relevance only the share purchase price is adjusted to the lower share price.

Taking our example if Peter had a total investment of Rs. 8000, we would assume that his share price would be equal to the lower share price of Adam i.e. Rs. 80/share. Thus, total shares that Peter should have will be (Rs. 8000/80) = 100 shares. Peter already has 80 shares of the Startup so he basically should get (100 - 80) = 20 more shares from the Startup.

Weighted Average

The weighted average anti-dilution protection takes into account the proportional relevance of the total subscription price paid by the first investor and the later investor. Even this will determine a new price for the first investor, which ofcourse will be lower than his purchase price. This will be kind of average of the purchase price of first investor and the second investor after the individual prices are weighted. What this means?

Well the purchase price are multiplied by a certain number of shares and then the total divided by total number of shares. Its like if, we buy 5 apples @ Rs. 100/apple and then buy 10 apples @ Rs. 80/apple then to get the average price for each apple we multiply 5 apples by Rs. 100 (i.e. Rs. 500) and then multiply 10 apples by Rs. 80 (i.e. Rs. 800). The total money we paid for apples is Rs. 1300. To calculate weighted average we would divide Rs. 1300 by 15 apples (5 + 10) which will be Rs. 86.87. This is exactly what the weighted average method does to calculate a new price for shares.

So when a company is selling its shares to the first investor it is assumed that all the shares are valued at the price at which investor buys. So taking our Startup, if it had 400 shares before any investor and then later 100 shares were given to Peter @ Rs. 100/shares. So now Startup had 500 shares each valued at Rs. 100. When Adam comes in he is offered let’s say another 100 shares @ Rs. 80/share. When we do a weighted average as we did with our apples the total of 500 shares * Rs. 100 and 100 shares * Rs. 80 is the total money paid = Rs. 58000. The total shares issued are 600 (500 + 100). So the new share price for Peter will be Rs. 96.6. Thus Peter should have 82.8 shares (8000/96.6). Rounding off Peter already has 80 shares so he will get 3 more shares.

So we see that Weighted Average is much better for the promoter of the Company. The shares of the company before the second investor comes into the company are referred to as outstanding shares. In the above example outstanding shares were 500.

Broad Based and Narrow Based:

The only difference between the broad based and narrow based weighted average is the definition of outstanding shares. For narrow based we consider only issued Preference Shares and Equity Shares. Whereas for broad based we will include Equity Shares outstanding or issuable upon conversion or exercise of all Preference Shares, warrants, convertible debentures, options and any other contingent right to Equity Shares. Which one is better?

Broad Based is more beneficial for the company and the promoter. Whereas, the Narrow Based is more beneficial for the Investor. Though as a lawyer you need not know more than which is better for whom. But as a company an investor you should know your math, these small language changes can mean huge difference in price for you.

How do free shares get issued legally?

I came across articles which discussed the complex legal problem that issue of free shares pose including satisfying consideration requirements under the Indian Contract Act, 1872 and the need of complying with shares for discount provisions under the Companies Act. No matter how complicated it seems these issues are not relevant, because in most cases when an anti-dilution comes into play no shares are actually issued. Confusing? Right.

The complexity of issuing free shares is bypassed by holding convertible preference shares. These convertible preference shares get converted into equity shares at a predetermined ratio. Ideally one preference share at a future date gets converted into one equity share. So when we decide to issue free share instead of actually issuing new shares we just change the ratio of conversion, thereby making the preference shares getting converted into more equity shares.

So in our example if Peter had 100 preference shares of Startup. The conversion ratio is 1, which means each preference share is convertible into one equity share. Now under full ratchet anti-dilution we had to issue him 20 more shares. So what we do is make the ratio 1.2, which means for his each preference share he will get issued 1.2 equity shares. Thus, for his 100 shares he will get 120 (1.2 * 100) equity shares when converted at a future point of time. So Peter is happy with his anti-dilution protection, even though no new shares get issued to him instantly. 

Under the Indian FDI policy the problem is more complex though, because the ratio has to be determined at the time of issue and then there is requirement of the minimum subscription price. There can also be a problem when shares are already converted or equity shares are issued to an investor. Solving those issues I consider outside the scope of this article. But rest assured there are solutions to it (maybe in the next article J).

How does it effect the Startup, the Promoters, Peter and Adam?

Peter should be happy he gets free share. He will try to secure as many free shares he can so he would want there to be a full ratchet anti-dilution protection. He should be ok even if he gets weighted average anti-dilution.

An anti-dilution protection for an early investor is never a good news for a later investor so Adam would not be too happy about it. But he will ensure that he gets the percentage of the company he wants anti-dilution or not. So even if free shares are being given to Peter as long as Adams investment doesn’t get affected he will be ok. This also is the most dangerous aspect of an anti-dilution. Lets just take an example:

Consider Startup had total 80 shares : 60 (75%) shares with Promoters and 20 (25%) shares with Peter. Now Adam says he wants 20% of the Company irrespective of any adjustments. So we will issue him ideally 20 more shares which would then mean that Startup will have 100 shares : Promoter - 60 (60%), Peter – 20 (20%) and Adam – 20 (20%).

But, we had an anti-dilution lets say because of which 20 more shares have to be issued to Peter now Startup will have 120 shares : Promoter - 60 (50%), Peter – 40 (33.33%) and Adam – 20 (16.67%). This means that Adam has dropped from 20% to 16.67% as a result of anti-dilution protection for Peter. And look at Promoter who has dropped from a majority 60% stake to now 50% stake right on the border line.

To further cause him problems Adam will now want more shares because he wanted 20% of the Startup, irrespective of adjustments. To give this either more shares can be issued further triggering anti-dilution as price will further fall or Promoter gives some of his shares to Adam, let’s consider he choses the later. Startup with 120 shares will have: Promoter – 56 (46.67%, 4 shares given to Adam), Peter – 40 (33.33%) and Adam – 24 (20%).

Now, Adam is happy he got 20%, Peter is happy he now holds 33.33% of the company from the earlier 20%. But see what happened to Promoter – he fell from 75% of the Company to 46.67%, so he is no longer in control of the Company. This is how promoters get pushed out from their company and make no profits in their first ventures.

Anti-dilution can spell bad news for Promoters. Its rare to have an investment without anti-dilution but efforts can be made to ensure that less free shares get issued. The best way though to prevent is that  - (i) Ensure that company does well and need not reduce Company Valuation or need further investment (ii) and give shares to investors at reasonable rates not a overly inflated price. 

Arpit Ratan

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