Negotiating a venture capital financing is often difficult for those not familiar with the meaning of some common VC deal terms. Share price and liquidation preference are among the most sensitive terms when determining the value of equity held by VCs and company founders. In comparison, the inclusion of anti-dilution protection in a deal has the potential to exert nearly as large an effect on returns, but is generally much less well understood, particularly by first-time entrepreneurs seeking funding.
I therefore thought I’d use this post as an opportunity to introduce the basics of anti-dilution provisions and what they mean to VCs and common stockholders. I will discuss some common types of anti-dilution protections in a follow-up post next week.
What is dilution?
Broadly speaking, dilution occurs anytime new shares are issued in a company. For example, if a particular stockholder owns 100 shares in a company that has 1,000 total shares outstanding, he owns 10% of the company. If an additional 1,000 shares are later issued, the stockholder is diluted since he now owns 100 out of 2000 shares, or 5% of the company.
By the above definition, dilution occurs every time a new financing occurs. When VCs make an investment, they purchase shares which are issued at the time of the financing. This dilutes the percent ownership of all existing stockholders, since new shares are issued. However, if all goes well and each round of financing is accompanied by an increased share valuation, the reduction in the actual percent ownership for each stockholder is more than offset by the increased value of each share.
If, on the other hand, the company experiences a “down round”, i.e. a round of financing that comes with a reduced valuation compared with the previous finance round, the dilution causes a reduction in the actual monetary value of each shareholder’s equity. To protect themselves from this eventuality, VCs often include anti-dilution protections in term sheets.
Who is protected and how?
The first thing to realize about anti-dilution protections is that they protect the preferred stockholders from previous rounds in the event of a down round, but do not protect company founders and other common stockholders. In fact, when a VC exercises his anti-dilution rights, it actually causes additional dilution to common stockholders.
The basic mechanism by which VCs are protected by anti-dilution provisions is that the conversion price (the price at which their original investment is converted to shares) is reduced. The actual amount by which the conversion price is reduced is determined by the type of anti-dilution protection in the term sheet, but the basic effect is that the VC gets to purchase shares at a lower price than the original purchase price. So although this helps offset the dilutive effect on the protected VCs, it leads to additional shares outstanding, and therefore magnifies the dilutive effect of the down round for all non-protected shareholders such as company founders and management.
Anti-dilution protections become an even more important factor in a down-economy. Anyone negotiating a term sheet in the current economic climate must carefully consider the anti-dilution protections included. Down rounds have become increasingly common as companies struggle in a more difficult market, so anti-dilution protections are more relevant than ever.
- All shareholders are diluted whenever new shares are issued, but as long as share valuation increases with each finance round, the dollar value of everyone’s equity stake still increases.
- In the event of a down round, VCs can exercise their anti-dilution protections which help offset the dilutive effect for the VC.
- Anti-dilution protections only protect preferred stockholders, and actually lead to additional dilution of common stockholders at a down round.