Turning the ratchet - understanding anti-dilution rights in venture capital
In the third of a series of blogs aimed at demystifying common provisions found in venture capital term sheets (with the hope of accelerating the negotiation process between investors and founders), Peter Sugden looks at anti-dilution rights.
What are anti-dilution rights?
Anti-dilution rights are a form of economic protection for an investor against the valuation of a company dropping following its investment.
To reduce venture capital investment down to its crudest level, investors invest money in companies to help them develop and to drive the valuation of the company up. However, to borrow from A Midsummer Night's Dream, the course of
true love investment never did does not always run smooth.
After taking on one round of venture capital investment, early-stage companies may find themselves needing to go through a further funding round where the valuation of the company is lower than the valuation determined by the investors in the previous round – or what is commonly known as a "down round". It is on down rounds where anti-dilution rights come to the fore.
What do anti-dilution rights do?
Where a company issues additional shares (or convertible securities) to new investors at a price that is lower than the price paid by previous investors, any previous investors who have anti-dilution rights will have the right to receive additional shares at no or minimal cost in order to compensate them for their economic dilution.
What do you mean by economic dilution?
The issue of shares to investors in a company establishes the share price and total valuation of a company. The value of an investor's stake in a company will be reduced (or "diluted" from an economic perspective) if a new investor pays a lower price per share for its investment than the original investor paid in an earlier round of financing.
How do you determine how many shares the original investor will get when anti-dilution rights apply?
The precise number of shares to be issued on a down round to investors with anti-dilution rights depends on whether the anti-dilution protection is calculated on a full ratchet basis or a weighted average basis:
- full ratchet protection is very investor-friendly and has the effect of putting the investor in the position as if it had invested for shares at the share price established in the down round. In effect, the original investor gets to reprice the full amount of its investment at the new, lower share price. Importantly, a full ratchet mechanism is binary - it takes no account of the proportionate effect of the down round (ie. the amount of money being raised in the down round), and therefore can have extreme consequences for other shareholders, who may find their shareholdings being heavily diluted by a wholesale repricing of a prior investment.
- a weighted average provision takes a more balanced approach, and takes into account the number of shares issued at the reduced price in repricing the original investment. It balances the valuation of the company against the total capital increase in the dilutive financing round. Accordingly, a down round in which £500,000 of capital is raised will result in a significantly smaller number of anti-dilution shares being issued to the original investor than a round at the same price in which £5 million of capital is raised, because proportionately the impact of a smaller raise is less economically dilutive to the original investor than a large raise.
It is important to note that full ratchet protection is very unusual and, on the UK venture scene, anti-dilution rights predominantly apply a weighted average basis to determine the number of new shares to be issued.
How does that work from a practical point of view?
In the UK, venture deals incorporating anti-dilution rights typically provide for investors to be issued with new shares structured as a bonus issue of shares paid for by a capitalisation of reserves (eg. the share premium account). However, if the company does not have sufficient reserves to capitalise to make the bonus issue, investors will usually be able to subscribe for the new shares at nominal value instead. It is for this reason that shares which carry anti-dilution rights should, from the perspective of an investor, carry a low nominal value.
So what should a founder do if they see anti-dilution rights in a term sheet?
The first thing to bear in mind is that anti-dilution rights are not unusual. It is certainly not the case that they appear in all UK venture deals, but they are very common (you won't generally see them being requested on angel investments in the UK as they will prevent the angel investors obtaining SEIS/EIS tax reliefs). With that as a backdrop, here are four key things for founders to consider when an investor requests anti-dilution rights:
- Valuing early-stage companies is sometimes more of an art than a science. I have written previously about the importance of founders raising investment using realistic valuations and how a founder who pushes extremely hard for an optimistic valuation may end up having to accept some deal terms which give greater protection to an investor than if a more realistic valuation had been pursued (see, for example, my article on liquidation preferences which notes that a founder giving an investor a strong liquidation preference (eg. a participating preference) is effectively a side bet between the investor and the founder regarding the true valuation of a company). A similar point is true of anti-dilution rights. Remember that anti-dilution rights only apply on a down round. Accordingly, founders can mitigate the impact of anti-dilution rights by ensuring that valuations are realistic at the time of raising an investment so that, unexpected downturns aside, the likelihood of a down round is reduced. As the well-known venture capitalist and blogger Brad Feld writes, founders should focus on "(a) minimizing [the] impact [of anti-dilution rights] and (b) building value in [their] company after the financing so they don’t ever come into play".
- Founders should also consider whether any rights they hold (eg. board rights, veto rights, etc) are linked to them continuing to hold a certain percentage of the share capital in the company, and consider what the impact could be on these rights in a scenario where further shares are issued to investors under anti-dilution provisions on a down round.
- Full ratchet anti-dilution rights are very uncommon at the time of writing (October 2021) and a founder should consider very carefully the possible commercial implications for a company of giving these rights to an incoming investor. Full ratchet anti-dilution rights can hamstring a business which suffers an unexpected downturn by, effectively, making a down round viable only as a matter of a last resort.
- Finally, as with all contractual protections, it is important to bear in mind that the true power of anti-dilution rights sometimes lies in the negotiating power they bestow on an investor. Where a company goes through a down round, anti-dilution rights – however structured – have the effect of diluting founders at the expense of investors. It is a key principle of venture capital investing that, for a company to flourish, its management team must be properly incentivised in terms of their equity stake in the business. An enforcement of contractual anti-dilution rights in full could have a demotivating impact on a management team if it dilutes a founder's shareholding too much. Therefore, the power of anti-dilution rights in this scenario is often to give the investor leverage to negotiate new contractual rights or to assume more control over the terms of the down round.