Anti-Dilution Provisions: Definition, Types, and Impact

What is an anti-dilution provision?

An anti-dilution provision is a clause in a company charter or investor agreement that protects holders of convertible securities (such as preferred stock or convertible debt) from reductions in their ownership percentage when the company issues new shares at a lower price than earlier rounds. It accomplishes this by adjusting the conversion price of the convertible securities so the investor can convert into a larger number of common shares.

How they protect investors

When a company issues new shares, the total shares outstanding increases and each existing shareholder’s percentage ownership falls (dilution). Anti-dilution provisions reduce that effect by lowering the conversion price of convertible securities when a later issuance occurs at a lower price. That increases the number of common shares an investor receives on conversion, helping preserve their ownership stake and economic value.

Simple example of dilution:
* An investor owns 200,000 shares of a company with 1,000,000 shares outstanding (20% ownership).
* The company issues 1,000,000 new shares. Total shares become 2,000,000.
* The investor still has 200,000 shares but now owns 10% of the company.

Main types of anti-dilution clauses

Full ratchet

• Definition: Resets the conversion price of existing convertible securities to the lowest price at which new shares are issued, regardless of how many new shares are issued.
• Effect: Offers maximum protection to early investors — they convert at the new, lower price and receive many more common shares.
• Pros for investors: Preserves ownership percentage in down rounds.
• Cons for the company and common shareholders: Can cause large dilution of common equity and deter future investors; complicates fundraising and negotiations.

Weighted average

• Definition: Adjusts the conversion price downward using a formula that weights the impact of the new issuance by both price and number of shares. The new conversion price falls between the old price and the new issue price.
• Common formula (as used in many agreements):
  C2 = C1 × (A + B) / (A + C)
  Where:
• C2 = new conversion price
• C1 = old conversion price
• A = number of outstanding shares before the new issue
• B = total consideration received by the company for the new issue
• C = number of new shares issued
• Variations:
• Broad-based: Includes nearly all outstanding shares (e.g., includes options and warrants) — results in a milder adjustment.
• Narrow-based: Considers a narrower set of shares (typically only common stock outstanding before the round) — leads to a larger adjustment than broad-based.
• Pros/cons: More balanced than full ratchet; protects investors moderately while limiting dilution to common shareholders and making future financing easier.

When anti-dilution provisions are triggered

These provisions typically trigger when the company issues new shares at a price per share lower than the conversion price originally paid by the convertible security holders (i.e., a down round). The triggering mechanism and resulting adjustment depend on the clause’s exact language (full ratchet vs weighted average, broad vs narrow base).

Drawbacks and challenges

• Complexity: Calculations and exceptions can be detailed and time-consuming, which can slow financing rounds.
• Dilution of common shareholders: Adjustments increase the number of shares issued on conversion, reducing existing common holders’ ownership.
• Investor conflicts: Different investors may seek different protections, complicating capital structure and negotiations.
• Impact on valuation and fundraising: Prospective investors may demand lower valuations or different terms to offset anti-dilution risk.

Practical guidance

• Investors should negotiate the type and scope of anti-dilution protection (full ratchet vs weighted average; broad vs narrow base) based on risk tolerance and expected future rounds.
• Founders and companies should weigh investor protections against future fundraising flexibility and common shareholder dilution; weighted-average, broad-based formulas are often a compromise.
• Carefully review contract language to understand triggers, exclusions (e.g., shares issued for acquisitions, employee option pools), and calculation methods.

Bottom line

Anti-dilution provisions are important protections for holders of convertible securities, designed to preserve ownership and economic value when a company issues shares at lower prices. Full ratchet provisions offer strong investor protection but can heavily dilute common shareholders and complicate future fundraising. Weighted average provisions provide a more moderate, negotiable solution. Both investors and companies should understand the trade-offs and clearly specify the calculation method and scope in agreements.