Anti dilution clause: protecting an investor's price in a down round

Sample clause

a shareholders agreement for Kookaburra Energy Storage Pty Ltd, a fictional Newcastle battery company whose seed investor, Ridgeline Seed Fund, holds 1,000,000 seed preference shares bought at $2.00 each

9. Anti Dilution 9.1 If the Company issues Shares at a price per Share below the Seed Price (a Down Round Issue), other than an Excluded Issue, the Company must issue to each Seed Investor, for no additional payment, the number of additional Ordinary Shares that would have been issued to it had its subscription been made at the Adjusted Price. 9.2 The Adjusted Price is the Seed Price multiplied by (A + B) and divided by (A + C), where A is the number of Shares on issue immediately before the Down Round Issue on a fully diluted basis, B is the number of Shares the Down Round Issue consideration would buy at the Seed Price, and C is the number of Shares actually issued in the Down Round Issue. 9.3 Excluded Issues are issues under the Employee Share Plan, issues on conversion of Seed Preference Shares, and any issue the Seed Investor Majority approves in writing. 9.4 Each Shareholder must vote for any resolution, and waive any pre emptive right, needed to give effect to this clause.

Sample wording, not legal advice.

Variants

What to negotiate

• Broad based or narrow based

  The broad based formula counts all shares on a fully diluted basis, including options and the employee pool, which spreads the adjustment and keeps it small. The narrow based formula counts fewer shares, so the investor receives more. Founders almost always push for broad based, and it has become the usual expectation in Australian, UK and US venture deals.

• Excluded issues

  Anti dilution should not fire on ordinary events. Founders want exclusions for employee share plan grants, conversions of existing securities, shares issued in an acquisition, and issues the investors approve. Investors accept those but watch for a broad exclusion covering any board approved issue, which would allow a down round without any adjustment at all.

• Who carries the cost

  The extra shares issued to the protected investor dilute everyone else, including the new down round investor, who may insist the adjustment is waived as a condition of investing. That negotiation usually happens inside the down round itself, which is why earlier investors seek wording requiring their own class majority to agree to any waiver.

• Mechanics in an Australian company

  Australian companies usually give effect to an adjustment by issuing bonus shares or by changing the conversion ratio of preference shares into ordinary shares. Either route needs authority in the constitution and the share terms, and cooperation from other shareholders, such as a waiver of pre emptive rights, which the clause should require in advance.

The risk of leaving it out

Without anti dilution protection, an investor that paid a high price carries the full loss of value when the company later raises at a lower price, while new investors buy in cheaply. Earlier investors then become reluctant to support a down round the company may need to survive, and argue for protection at the worst possible moment.

The two formulas worked through

Take a seed investor that paid $2.00 for 1,000,000 shares, $2,000,000 in total. The company later raises $1,500,000 at $1.25 a share, issuing 1,200,000 new shares, when 6,000,000 shares were on issue on a fully diluted basis. Under the broad based formula B is the 750,000 shares the new money would have bought at $2.00, so the adjusted price is $2.00 multiplied by 6,750,000 and divided by 7,200,000, which is $1.875. The investor's $2,000,000 now equals about 1,066,667 shares, so it receives about 66,667 extra shares. Counting only 5,000,000 issued shares, a narrow based approach, the price falls to about $1.855 and the extra shares rise to about 78,261. Under a full ratchet the price becomes $1.25 and the investor receives 600,000 extra shares.

The legal framework and market documents

In Australia the adjustment has to work within the Corporations Act and the company's constitution, because the rights attached to preference shares must be set out in the constitution or approved by special resolution. Market model documents, such as the UK Private Capital model documents for Series A rounds and the National Venture Capital Association's model legal documents in the United States, are common reference points when the formula is negotiated, although neither is compulsory and each is adapted deal by deal.

Where it sits in a generated document

A generated shareholders agreement carries anti dilution as a numbered clause, with the formula written out in words and its terms defined in sub clauses, next to the pre emptive rights clause it depends on. Prices and share counts are written in as content, so any worked figures in a draft should be recalculated before signing. The document does not cite the Corporations Act.

Documents that carry this clause

Shareholders agreement templateA veterinary diagnostics company has just taken $1.5 million from one seed fund. The founders keep 80 percent between them, so the whole agreement turns on a single number: the 75 percent consent threshold that puts the investor on one side of every decision that matters.

Questions people ask