5 minutes, 11 links


Updated September 15, 2023
Raising Venture Capital

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Definition Anti-dilution provisions in a term sheet adjust the number of common shares into which preferred shares convert in the event of a down round or other stock dilution. The purpose of these provisions is to protect investors’ stock ownership percentage in a company.

When negotiating anti-dilution clauses, lawyers may not get into the details of how anti-dilution works. They should, however, advise you to request contingencies to anti-dilution clauses. These contingencies allow space—or “carve-outs”—for founders to get around the clause in certain standard circumstances, like issuing shares in an acquisition, offering options for employees, or taking on venture debt that allows you to do those things without triggering anti-dilution.

Anti-dilution can be calculated by a broad-based weighted average (or BBWA), or as full ratchet. BBWA is absolutely customary, whereas ratchet-based anti-dilution is very atypical. If you’re interested in reading more about either, we recommend reading Yokum’s “What is weighted average anti-dilution protection?” and “What is full ratchet anti-dilution protection?” at Startup Company Lawyer.

Definition Full ratchet anti-dilution is a form of anti-dilution that adjusts the rate at which convertible preferred stock can be exchanged for common stock to reflect the lower price of shares issued in a down round. This adjustment recalculates the number of shares of common stock into which each share of preferred stock is convertible by dividing the price per share when the preferred stock was purchased by the price per share of common stock in the down round.* Full ratchet anti-dilution provisions benefit investors over founders because of the disparity they create between the values of common and preferred stock,* and they are relatively rare compared to weighted average anti-dilution provisions, which create less disparity.

If you raised an investment at $5 per share in one round, then raised a later round at $1 per share, each share of convertible preferred stock protected by full ratchet anti-dilution in the earlier round would be convertible into five shares of common stock. Those additional shares have to come from somewhere, which is what makes this approach controversial.

Definition Weighted average anti-dilution is a form of anti-dilution that uses a relative (weighted) formula in a down round or other stock dilution to decrease the price at which preferred stock can convert into common stock. This form of anti-dilution takes into account not only the new price per share but also the extent of the would-be dilution. As a result of its relative formula, weighted average anti-dilution produces a smaller adjustment than full ratchet anti-dilution* and is accordingly the more founder-friendly option.*

The formula for weighted average anti-dilution compares:

  • the amount of money previously raised by the company and the price per share at which it was raised, with

  • the amount of money currently being raised by the company in a down round or other stock dilution, and the price per share at which this new money is raised.

The formula is typically expressed as:

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  • CP2 = new conversion price
  • CP1 = conversion price before the dilution
  • A = number of shares before the dilution
  • B = number of new shares that would have been issued if the conversion price before the dilution (CP1) applied
  • C = number of new shares actually issued

danger If you are looking at a weighted average anti-dilution provision, pay close attention to the way the calculation is described. Different versions of this provision can especially vary in terms of how they calculate the number of shares before the down round or other stock dilution (variable A above).

important We strongly recommend consulting an attorney about any anti-dilution provisions you have been presented with or are considering. These calculations can get extremely complicated, and they can have serious downstream consequences.

That said, if you’re interested in learning more about how the calculations work, we recommend reviewing Cooley’s “What You Need to Know About Down Round Financings,” Frank Demmler’s “Weighted Average Anti-Dilution Protection,” and Yoichiro Takum’s “What is weighted average anti-dilution protection?.”

Conditions Precedent

Conditions precedent to financing is legalese for “these things have to happen before this deal is actually binding,” which should be a reminder that term sheets are usually not legally binding documents. This part of the term sheet can range in size, may include several items, and, as Brad Feld writes, “if you can dream it, it has probably been done.” Common items include, per Brad Feld:

  • “approval by investors’ partnerships”

  • “rights offering to be completed by company”

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