Antidilution: Understanding Its Role with Investors
Antidilution Rights
Another feature capital raisers must be aware is antidilution rights. Antidilution rights exist to offer incoming investors another source of downside value protection by ensuring that, if the valuation of a financing round subsequent to the current one is lower than the current valuation, the current investors don’t lose value. The implication of this is that if a financing at a lower valuation (called a “down round”) does take place, the loss of value falls on all the investors that are not protected by antidilution rights. This usually (but not always) means that the founders suffer the full brunt of a loss in value.
A related reason that antidilution rights exist is to give the company the opportunity to prove their value. As in any negotiation, the possibility exists that there will emerge a gap between the prospective seller’s and buyer’s respective valuations. Sometimes, when that occurs, the gap is bridged by agreeing to antidilution rights whereby if the company’s value fails to live up to the seller’s expectations, then the value is corrected after the fact. On the other hand, if subsequent rounds are higher than the antidilution threshold, then the sellers are proven right, nobody is diluted, and all the parties continue on happily.
How do Antidilution Rights Work?
The following is an example of how antidilution rights work. Consider a company that raises $2 million from investors at an $8 million pre-money valuation, leading to a $10 million post-money valuation. On a fully diluted basis, the investor owns 20% of the company’s equity, which is, of course, valued at $2 million.
Things don’t go well for the company over the course of the following year, and they are forced to raise another $1 million at a $4 million pre-money valuation ($5 million post) in order to continue operating. The previous investor’s stake of 20% is now worth $1 million, per the current round’s pricing. However, the investor has antidilution rights, which means that investor is issued new shares (in this case, the number of their shares will double) so that their value of their holding in the company remains $2 million, but now they will own 40% of the company.
That additional 20% equity stake has to come from somewhere—and the only place it generally can come from is the investors without antidilution rights: again, the founders. The founders’ stake in their own company has gone from 80% to 40% (40% now held by previous investors and 20% by the new investors). Not only do the founders have (much) fewer shares in their own company, but they have likely lost control as well!
Full Ratchet vs. Partial Ratchet
Antidilution rights come in two different forms: full ratchet and partial ratchet. Full ratchet means that the shareholders without such rights bear the full brunt of the down round. Partial ratchet antidilution means that the protected shareholders receive partial antidilution protection, but they nevertheless suffer some pain when and if a down round takes place. We tend to see partial ratchets less frequently than full ratchet, but they do exist.
Antidilution rights are a powerful, and some would say punitive term in an equity investment transaction. Such rights frequently make the effective economic valuation of the investment much less than the headline number.
If you are confronted with antidilution terms in a potential investment, make sure that you understand the impact of such terms on your effective valuation and by extension your personal wealth.
