What is anti-dilution protection?

July 28, 2007

Almost all venture financings have some form of anti-dilution protection for investors. In the context of a venture financing, anti-dilution protection refers to protection from dilution when shares of stock of stock are sold at a price per share less than the price paid by earlier investors. This is known as price-based anti-dilution protection. Anti-dilution protection, along with the liquidation preference, are two of the fundamental features distinguishing preferred stock typically sold to investors from common stock generally held by founders and employees.

Preferred stock is normally convertible at the option of the holder at any time into common stock, usually on a share for share basis, and is typically automatically converted upon the occurrence of a qualified initial public offering. Price-based anti-dilution adjustments involve increasing the number of shares of common stock into which each share of preferred stock is convertible. In addition, an anti-dilution adjustment will affect the voting rights of the company’s stockholders because the preferred stockholder is almost always entitled to vote on an as-converted to common-stock basis. The primary difference between the various anti-dilution formulas to be described in upcoming posts is the magnitude of the adjustment under different circumstances.

Although an investor may be diluted in the sense that it may own a smaller percentage of the company following any new stock issuance, the value of the portion of the company owned by such investor has theoretically increased due to the increase in the total company valuation due to the higher price per share paid by the new investor. Occasionally, absolute anti-dilution protection is requested by investors (or executives) against any dilution arising as a result of the subsequent sale of stock, which basically guarantees a certain percentage ownership of the company for a specified time period or until the occurrence of a certain event, such as a initial public offering. However, these provisions may impair the company’s ability to raise financing.

The other type of anti-dilution protection that preferred stock investors always obtain is structural anti-dilution protection. This is an adjustment of the conversion price of their preferred stock into common stock upon the occurrence of any subdivisions or combinations of common stock, stock dividends and other distributions, reorganizations, reclassifications or similar events affecting the common stock. For example, in a stock split, an investor will expect a provision to the effect that, to the extent the common stock is subdivided by a stock split into a greater number of shares of common stock, the conversion price of each series of preferred stock then in effect shall, concurrently with the effectiveness of such subdivision, be proportionally decreased. This type of anti-dilution protection ensures that the investor holding preferred stock is treated as if such investor held common stock without the need to actually convert into common stock and lose the features associated with the preferred stock held by such investor.

[Note:  this post and others on anti-dilution are based on (and complete sections of text copied from) an article titled "The Venture Capital Anti-Dilution Solution" written by Mike O'Donnell and Anton Commissaris.]